CHAPTER 1: OVERVIEW OF FINANCIAL MANAGEMENT

INTRODUCTION

Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfil their business
activities. In the modern world, all the activities are concerned with the economic activities and
very particular to earning profit through any venture or activities. The entire business activities
are directly related with making profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labour, interest given to capital and profit given
to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.

MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. Finance also is referred as the provision of money at the time when it
is needed. Finance function is the procurement of funds and their effective utilization in business
concerns. The concept of finance includes capital, funds, money, and amount. But each word is
having unique meaning. Studying and understanding the concept of finance become an important
part of the business concern.

DEFINITION OF FINANCE

- According to Khan and Jain, “Finance is the art and science of managing money”.

- According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’.

- Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of
the management of funds’ and the management of fund as the system that includes
the circulation of money, the granting of credit, the making of investments, and the
provision of banking facilities.

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DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall objectives of
a business enterprise”.

According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in
the business”.

In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in non-
financial fields of industry”.

Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business concern and the
business concern needs to adopt modern technology and application suitable to the global
environment.

According to the Encyclopedia of Social Sciences, “Corporation finance deals with the
financial problems of corporate enterprises. These problems include the financial aspects of
the promotion of new enterprises and their administration during early development, the
accounting problems connected with the distinction between capital and income, the
administrative questions created by growth and expansion, and finally, the financial adjustments
required for the bolstering up or rehabilitation of a corporation which has come into financial
difficulties”.

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TYPES OF FINANCE

Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names. Finance can be classified into two major parts:

Fig. 1.1 Types of Finance

Private Finance, which includes the Individual, Firms, Business or Corporate Financial
activities to meet the requirements.

Public Finance which concerns with revenue and disbursement of Government such as Central
Government, State Government and Semi-Government Financial matters.

DEFINITION OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management has been defined
by Solomon, “It is concerned with the efficient use of an important economic resource
namely, capital funds”. The most popular and acceptable definition of financial management as
given by S.C. Kuchal is that “Financial Management deals with procurement of funds and
their effective utilization in the business”.

Howard and Upton: Financial management “as an application of general managerial

principles to the area of financial decision-making.

Weston and Brigham: Financial management “is an area of financial decision-making,

harmonizing individual motives and enterprise goals”.

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Joshep and Massie: Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient
operations.

Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. The following are the
important scope of financial management;

1. Financial Management and Economics Economic concepts like micro and macroeconomics
are directly applied with the financial management approaches. Investment decisions, micro and
macro environmental factors are closely associated with the functions of financial manager.
Financial management also uses the economic equations like money value discount factor,
economic order quantity etc. Financial economics is one of the emerging area, which provides
immense opportunities to finance, and economical areas.

2. Financial Management and Accounting.

Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowadays, financial management and accounting
discipline are separate and interrelated.
3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.

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4. Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance

required for each process of production activities.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each

department and allocate the finance to the human resource department as wages, salary,
remuneration, commission, bonus, pension and other monetary benefits to the human resource
department. Hence, financial management is directly related with human resource management.

OBJECTIVES OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:

1. Profit maximization

2. Wealth maximization.

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Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the

business concern:

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.

(iii) Profit reduces risk of the business concern.

(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

(i) Profit maximization leads to exploiting workers and consumers.

(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.

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(iii) Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization
is also known as value maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.

(ii) Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business operation. It
provides extract value of the business concern.

(iii) Wealth maximization considers both time and risk of the business concern.

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(iv) Wealth maximization provides efficient allocation of resources.

(v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.

(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.

(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoy certain benefits.

(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.

(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern.

APPROACHES TO FINANCIAL MANAGEMENT

Financial management approach measures the scope of the financial management in various
fields, which include the essential part of the finance. Financial management is not a
revolutionary concept but an evolutionary. The definition and scope of financial management has
been changed from one period to another period and applied various innovations. Theoretical
points of view, financial management approach may be broadly divided into two major parts.

Traditional Approach

Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and the
traditionally accepted methods. Main part of the traditional approach is rising of funds for the
business concern. Traditional approach consists of the following important area:

- Arrangement of funds from lending body.

- Arrangement of funds through various financial instruments.

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- Finding out the various sources of funds.

FUNCTIONS OF FINANCE MANAGER

Finance function is one of the major parts of business organization, which involves the
permanent, and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization. Finance manager is one
of the important role players in the field of finance function. He must have entire knowledge in
the area of accounting, finance, economics and management. His position is highly critical and
analytical to solve various problems related to finance. A person who deals finance related
activities may be called finance manager. Finance manager performs the following major
functions:

1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.

2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.

3. Investment Decision

The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.

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4. Cash Management

Present days cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.

5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their
smooth running of the business concern and also maintain the business carefully to achieve the
goal of the business concern. The business goal can be achieved only with the help of effective
management of finance. We can’t neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial management is as follows:

Financial Planning

Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.

Acquisition of Funds

Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.

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Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.

Financial Decision

Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct
relationship with various department functions such as marketing, production personnel, etc.

Improve Profitability

Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the investors and
the business concern. Ultimate aim of any business concern will achieve the maximum profit and
higher profitability leads to maximize the wealth of the investors as well as the nation.

Promoting Savings

Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings. Nowadays financial management is also popularly known as business finance
or corporate finances. The business concern or corporate sectors cannot function without the
importance of the financial management.

MODEL QUESTIONS

1. What is finance? Define business finance.

2. Explain the types of finance.

3. Discuss the objectives of financial management.

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4. Critically evaluate various approaches to the financial management.

5. Explain the scope of financial management.

6. Discuss the role of financial manager.

7. Explain the importance of financial management.

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CHAPTER TWO: SOURCES OF FINANCING FOR COMPANIES

Introduction

The sources of finance are the various means by which the financial manager

Acquires funds to finance (he activities of the business enterprise ... These funds can be
obtained to start a new business or to finance the expansion of an existing business. The
financial manager makes the choice of where and how to get the finance... Basically, the
finances come from two main sources:

1) From within the company, known as internal finance

2) Outside the company, known as external finance. The external sources are further divided
into three> that is; short term, medium term' and long term. The choice of any of these sources
will depend on many considerations decided by the financial managers. We attempt an
explanation;

Sourcing money may be done for a variety of reasons. It may be for fixed assets acquisitions,
which involve new machineries or the construction of a new building. It may also be for the
development of new products. It may to increase the working capital needs essentially from
short term sources. Let us consider the factors that determine the amount of finance to a
business and the factors which influence the choice of finance! Thereafter, we return to the
sources of finance.

Factors which Determine the Amount and Type of Finance

1) the ownership of the business:

A sole proprietor’s capital will be limited to his or her accumulated savings and little borrowing
from financial institutions because of limited collateral securities. A partnership-will have the
resources of all the partners while a limited company can raise share capital (from ordinary and
preference shares) as well as borrow from debenture holders.

2) The stage of development of the business

An already existing business will raise funds easily than a new venture', This is because as the
business grows it acquires more asset's which it can use as collaterals to obtain hank loans
but new businesses lack credit worthiness. This explains why many of

(hem die at the introductory stage.

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3) The success record of the firm

A firm with a good record of performance, in terms of dividend paid to shareholders, amount of
declared profit will motivate lenders and investors. This will permit them issue additional
shares at a premium and raise more capital. However, it firm with a doubtful track record will
scare investors and have difficulties in raising additional funds for investment.

4) The state or situation of the economy

In times when the economy is experiencing a boom, businesses confidence will be very high
and finance could be raised from diverse sources. However, when there is a downturn in the
economy (recession or depression) business confidence will drop and finance will be hard to
come by and investments will fall off.

5) The political state of the economy

Most businesses will find it difficult to raise finance in periods of political instability. The
fear is that the regime may change creating new challenges for the firms and financial
institutions. The regulatory instruments may change making it difficult to raise
funds; especially during inflationary periods. Investors and lenders will prefer real financial
assets acquisitions.

6) Government Monetary and Fiscal Policies

A monetary policy which is a credit squeeze (a contractionary monetary policy) may create
difficulties of borrowing from financial institutions by firms. Also investors may find
government securities more profitable to purchase than to invest in company. Contractionary
fiscal policies will reduce disposable income because of high taxation. Falling incomes will
discourage savings as a means of investment through commercial banks. On the other hand,
expansionary policies will increase incomes and encourage savings which are surpluses
needed by firms for expansion and growth.

Factors affecting the Choice of Finance

In the examples below, the factors affecting a choice of finance are discussed in relation to
choosing finance for expansion.

- The p u r p o s e of the finance: A golden rule is that sources must be matched with
uses. E.g. a long-term business expansion plan is not financed by a bank overdraft.
- The cost of the finance: In return for providing equity capital, the owner expects a
return in the form of a share of profits (dividends in the case of shareholders). In return for
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providing loan capital, a financial institution will, charge interest on the amount borrowed (a
flat rate of interest) or on the amount outstanding (a true rate of interest).
- The control of the business: Issuing new voting shares in a company could lead
to a change of power in the board of directors if the existing shareholders are unable to buy
part of the issue. Using retained earnings does not affect control but may upset the owners if
their dividends a r e reduced. The use of loan capital will not affect voting control but the
financial institution may take control of fixed assets or impose conditions (e.g. restricting
dividend payments) a s part of the loan agreement.
- The tax benefits: The payment o f dividends is not deductible against the
corporation’s taxable p r o f i t s whereas the interest on. a loan is deductible. The helps to
reduce the tax base of the company.
- The exposure to r i s k : Equity exposes the company to less risk as the share
capital only has to be repaid when the company closes. If no profits are available) dividends
do not have to be paid. A loan on the other hand will have a repayment schedule for both
the capital and the interest, which must be met if the company is to avoid liquidation.
- Payment date: Interest on debts is fixed and must be paid on a specified date but
equity holders receive dividend only when the company has made enough profits. This
considerably reduces pressure on management. Equity financing is preferred for long-term
projects with prospects good returns.

Internal Sources of Finance

This is finance generated within the company and includes the following:

1) Personal Savings o f the owner

Personal savings are amounts of money that a business person has at his disposal. They
can use the money to invest in their own business. Although we will generally discuss personal
savings as a source or finance for small businesses, there are many examples where
businessmen have used substantial s u m s of their own money to help in financing a business
venture.

2) Retained Profits ( retained earnings)

It represents undistributed profits of a company which shareholders do not receive as dividend.

These earnings are re-in vested in the business and they serve as an internal source of finance.
The main reason for using retained earnings to finance new investments is to avoid interest

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and dividend, issue cost and the possibility of a change in control resulting from an issue of
new shares.

3) Working capital

It is the money used to pay for the day-to-day trading activities carried out by the business such
as the payment of salaries, rent, electricity and other bills.

It is calculated as; working capital= current assets, current liability.

Current assets are short term sources of finance such as stocks, debtors etc. They are highly j
liquid investments and can easily be converted into cash within a maximum period of 12
months.

Current liabilities are short term requirements for cash such as trade creditors, expense
creditors, tax owing) dividends owing and the amount of money that the business owes
to other people, groups or institutions which must be repaid within a period of 12 months,

Application Exercise

M and G company' acquires current assets amounting to 6,000,000 while it current liabilities
are worth 3,500,000 Frs.

Calculate its working capital

Working capital =current assets - current liabilities

= 6,000,000 - 3,500,000 = 2,500,000 Frs.

When current assets arc reduced from the business they serve as sources of finance.

4) Sale of Assets
Business balance sheets usually have several fixed assets on them. A fixed asset is any', tiling
that is not used up in the production of goods and services; such as land, building, fixture
and fittings, machinery, etc. At times, a business may be having a surplus of these assets and
may sell some to generate additional financial resources for the company in times of hardship.

5) Provision for Depreciation

This i s the money set aside f o r depreciation of assets which r e s u l t s i n reducing realized
profits w i t h o u t actually paying out any cash. Hence, depreciation is a non-cash expense.
Such cash is kept a s i d e and can be reinvested in the business as an internal source of
finance.
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6) Provision for Taxation

Money set aside to p a y taxes when due at a future date can be used to invest in the business.
This can generates some revenue before the due day for the payment of taxes.

7) Reducing Inventories or Stocks

Stocks can be run down to generate additional financial resources which can be used to
invest in the business. Also, s o m e idle fixed assets maybe leased o u t to other
investors. These activities also result in the generation of revenue which can be invested in
the business.

Advantages of Internal Sources of Finance

I) the repayment of such funds is not necessary

2) It is the cheapest source of finance as there is very little or no cost involved

3) No interest payment has to be made

4) The company does not suffer any pressure from creditors

5) It saves time, as it is easy to obtain

Disadvantages

1) It may lead to a misused of funds since no replacements are necessary

2) Inefficiency may arise because the funds may not be self-liquidation and there is lack of
competition

External Sources of Finance (sources of capital)

External financing is grouped into 3 categories:

1) Short term financing (short term sources)

2) Medium term financing

3) Long term financing

Short Term Sources of Finance

They are funds raise externally, usually for a short period of time less than one Year.
These funds are raised to meet variable, seasonal or temporary working capital
Requirements. Such funds cannot be used to finance long term projects. Borrowing from hanks
is a very important source of short term financing. Other sources of short term

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 financing include; bank overdraft) trade credit, bills discounting, factoring, commercial
papers and hank credit.

1) Bank Overdraft

It is a short term financial facility given to current account holders to withdraw

more than what they have in their accounts. Interest is paid only on the amount
overdrawn. Prior to the withdrawal the creditor negotiates the credit limit with the bank
manager. The business may then spend money up to the limit. In most cases,
reimbursements is within JO days and interest is charged on a daily bases on the amount
overdrawn. This facility gives the business great flexibility as it can pay bills even when cash
is not readily available. It also helps companies which have small cash flow problems
from the time. This means, if the business borrows only a small amount, it only pays a little
hit of interest. In Cameroon the rate varies between 5% and 10%. For example, a 100,000
Frs. Overdraft facility at 10% will cost 10, 000.as interest to the borrower.

NB When a hanker is asked by business customer for a loan or overdraft facility, he will
several factors known commonly by the mnemonic PARTS .

- Purpose
- Amount
- Repayment
- Term
- Security

P; The purpose; the loan request will he refused if tile purpose of the loan IS
(lot acceptable to the bank.

A: the amount of the loan, the customer must state exactly how 1l11ICh he wants to borrow.
The banker must verify, as much as he is able, to ascertain, that the amount required for
investment has been estimated correctly.

R: How will the loan b e repaid? Will the customer be able to obtain sufficient income to make
the necessary repayments?

T: Terms; w h a t will be the duration of the loan? Traditionally, banks have offered short ... term
loans and overdrafts, although medium-term loans are now quite common.

S: Does the loan require security? If so, is the proposed security adequate?
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2) Trade Credit

This is the highest' source of short term financing to business enterprises, This
involves the business buying goods or services and arranging to pay at a later date. This source
of finance is widely available to buyers who have proven to be credit worthy. Bil1s of
exchange are a major source of trade credit.

3) Factoring

This involves t h e sale of business debtors to a financial institution known as a

factor. In other words) factoring is when a company sells it book debts 1:0 another
company which undertakes the administration of the sale ledger and assume the risk of non-
payment. The f a c t o r company assumes responsibility for collecting the d e b t s and
deals directly with the debtors (customers). Services provided by f a c t o r
include the regularization of cash flow by paying invoices on agreed dates and the elimination
of bad debts if the business opts for factoring without recourse.

4) Bill Discounting

Firms do discount their bills of exchange and other securities with financial
institutions, such as; discount houses, merchant bank and investment banks in order to raise
funds to manage their activities.

5) Acceptance credit

It is a paper note given by banks to businessmen to borrow money directly within a

period of one year. This facility allows the customers to draw a bill of exchange on the hank
up to an agreed limit Payments are made at an agreed future dates. The bank accepts the
bills and arrange for them to be discounted on the discount market this facility is not as
flexible as an overdraft, but offers the advantage of cheaper borrowing.

6) Commercial Papers

Commercial p a p e r s represent a short term unsecured promissory note issued by large

corporations to investor’s ill minimum units of currencies. I n the USA, the minimum is about
$25000. The rates on commercial p a p e r s are less than those of banks. They have a
maturity period which varies between 2 and 12 months.

7) Foreign Borrowing

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 The export finance department such as ECaD (Export Credit Guarantee Department)
provides short term financing. These loans come from foreign banks denominated in foreign
currencies,

8) Borrowing from Cooperatives

This is a short term source of finance which operates in a similar way like bank loan
with the exception that the loans are repaid monthly and restricted only to members of the
cooperative.

Medium Term Sources of Finance

Medium term finance is one in which the time period varies from one year to five years, it is
usually for permanent working capital, small expansions modifications and replacements.
Medium term finance .maybe raised through the following ways:

1) Bank Lending

Borrowings from banks are an important source of finance to companies. Bank lending is still
mainly short term, although medium-term lending is quite common these days. Traditionally,
commercial hanks also known as clearing banks prefer to lend short term) it is recently that they
have extended their operations into medium and long term financing. Most businessmen
obtained bank loans from banks after presenting a security. Quite often, hanks grant loans to
businessmen taking into account some considerations, which include the credit worthiness of
the businessman.

2) Leasing

A lease is a contractual agreement between two parties, the "lessor» and the "lessee". The
lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under
terms of the lease to the lessor, for a specified period of time.

Leasing is therefore a form of rental. Leased assets have usually been plant and
machinery, cars and commercial vehicles, but might also be computers and office
equipment. There are two basic forms of lease: "operating leases" and finance leases".

a) Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

The lessor supplies the equipment to the lessee

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The lessor is responsible for servicing and maintaining the leased equipment,

The period of the lease is fairly short, less than the economic life of the assets, so that at the
end of the lease agreement, the lessor can either lease the equipment to someone else and
obtain a good rent for it or sell the equipment second-hand.

b) Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the assets expected u s e f u l life.
Suppose that a company decides to obtain a company car and finance the acquisition by means
of a finance lease. A car dealer will supply the car, a finance house will, agree (0 act' as
lessor in a finance leasing arrangement, and so will purchase the car from the, dealer and
lease it to the company. The company will take possession of the car from the car dealer, and
make regular payments (monthly, quarterly, Of annually) to the finance house under the terms
of the lease.

Important characteristics of a finance lease

The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is
not involved in this at all.

-The lease has a primary period, which 'covers all or most of the economic life of the asset.
At the end of the lease, the lessor would not be able, to lease the asset to someone else, as the
asset would be worn out. The lessor must, therefore, ensure that the lease payments during the
primary period pay for the full cost of the assets as well as provide the lessor with a suitable
return to his investment.

It is usual at the end of the primary lease period) to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent, Alternatively ,
the lessee might be allowed to sell t h e asset on the lessor's behalf (since the lessor is the
owner) and to keep most of the sate proceeds, paying only a small percentage (perhaps 15%) to
the lessor.

3) Hire Purchase

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the
exception that ownership of the goods passes to the hire purchase customer on payment of
the final credit instalment, whereas a lessee ~lever becomes the owner of the goods. Hire
purchase agreements usually involve a finance houses the supplier sells the goods to the

21
finance house. The supplier delivers the goods to the customer who will, eventually purchase
them. The hire purchase arrangement exists between the finance house and the customer. The
finance house will always insist that the hirer should pay a deposit towards the purchase price.
The size of tile deposit will depend on the finance company's policy and its assessment of the
hirer. This is in contrast to a finance lease, where the lessee might not be required to make any
large initial payment Hire Purchase is a method of acquiring assets without having to invest the
full amount in buying them. i Typically, a hire purchase agreement allows the hire purchaser
sole use of an asset for a period after which they have the right to buy it, often for a small or
nominal amount. The benefit of this system is that: companies gain immediate use of the asset
without having to pay a large amount for it or without having to borrow a large amount.

4) Franchising

Franchising is a method of e x p a n d i n g business on less capital than would otherwise

be needed. For suitable b u s i n e s s e s , it is an alternative to raising extra capital for
growth. Under a franchising arrangement, a franchisee p a y s a franchisor for the right to
operate a local business) under the franchisor's trade name. The franchisor must hear certain
costs (possibility for architect's work, establishment costs) legal costs, marketing costs and
the cost of other support services) and will charge the franchisee an initial franchise' fee to
cover set-up costs) relying on the subsequent regular payments by the. franchisee from the
operating profits. These regular payments will usually be a percentage of the
franchisee's turnover. Although the franchisor will probably pay a large part of the
initial investment cost of a franchisee's outlet, the franchisee will be expected (0
contribute a share of the investment himself. Tile franchisor m a y well help the franchisee to
obtain loan capital to provide his contribution of the investment cost.

The advantages of the franchise to the franchisor are as follows:

The capital outlay needed to expand the business is reduced substantially

The image of the business is improved because the franchisee will be motivated to achieve
good results and will have the authority to take whatever action they think tit to
improve the results.

The advantages of the franchise to franchisee are as follows:

- He obtains, ownership of the business for an agreed number of years (including stock
and premises, although premises might be lensed from the franchisor) together the backing of a
large organised marketing effort and experience from the franchisor.
22
 -The franchisee will be able to avoid some of the mistakes of many small
businesses, because the franchisor .as already learned from past mistakes and developed a
scheme that works.

5) Redeemable Debentures

A company may raise money capital by issuing debentures, A debenture is an ' instrument
issued by a company acknowledging debt under its company’s seal. The terms and
"conditions of the loan are written on the back of the documents. Beyond regular
payment of interest, the loan is reimbursable at a future date.

Long Term Sources of Finance

It is the finance that is raise to last in the business for a very long time and even in some cases
fore ver. This finance covers the acquisition of fixed assets and large scale expansion. This
means that it remains in the business until it shuts down 01' winds off.

The main source of long term finance is through. The issue of shares of all classes 10 the in
vesting public; (ordinary and preference shares) and debts or loan capital
commonly known as debentures. All these categories of investment can last in the business for
more than 10 years.

In a small business like a sore proprietorship where there is only a single owner or a
partnership where there are a few partners, long term finances are usually provided by savings,
contributions and borrowing. However, in 'joint stock companies or public companies the
capital is raised from 3 main sources.

1) Equity or Ordinary Share Capital (Common Stocks)

This is the basic form of long term finance. Equity holders are the real owners of the company.
The term "shareholder" indicates that they own a share or a part of a company. The
proportionate number of shareholders determines their stakes in the business. It is the
ownership of share certificates that empowers the shareholder and gives him In the ultimate
control over the company and the greatest say in the business. However, they have little
influence on its day to day activities which are handled by salaried managers
appointed by the board of directors \v110 themselves are elected by the shareholders. Equity
holders do not earn a fixed dividend. The rate of dividend paid to' them is in function of
resident profit. The dividend per share (DPS) to ordinary shareholders is not fixed

23
 because it depends on the residual profit, that is, profit which is left after the other
stakeholders have been compensated (debenture and preference shareholders. they are
known as residual claimants .. In a year when profits are low, equity holders may earn
nothing and in a year when profits are high they also receive all high rate of dividend.
When the company is winding up> they arc the last call· on company' s assets,
Ordinary shareholders) therefore> bear the greatest risk. Mostly importantly, equity holders
have voting rights, which they exercise in AGM (Annual General Meetings), in selecting or
electing board of directors and formulating the policy decisions of the company for the coming
year. The advantage of issuing ordinary shares into a business is that, the business does not
owe its owners, regardless of its performance.

2) Preference Shares

These are financial securities issue to those individuals and institutions provide long term
financing to joint stock companies. They are known as preferred shares because their owners
receive a fixed rate of dividend annually on their investment and they are given priority
over ordinary shareholders. They are Own second to be paid after debenture
holders> when the company declares profit. They have no voting rights of ACM.
They bear little risk. In the event that the company is winding up, they have first claim on any
remaining assets of the company after all debt holders have been paid. The company has no
obligation to make up for any unpaid dividend in years when profits are ,
relatively low. However, cumulative preference shareholders can be paid in an-ear when
tile company's earnings improve.

Types of preferences

a) The participation preferences shares :

They have all rights that preference shareholders enjoy. In addition to the fixed rate of
dividend, they may be paid bonuses in a year the company makes high profits. they
sometimes assist in the running of the business at the request of the ordinary
shareholders. A right they can accept or decline.

b) Cumulative Preference Share

They are shares that their holders receive dividend in arrears, for example, if the
Company does not make profit for 3 years, and makes a high profit in the 4th year, all the
dividend for the past 3 years and the 41h year is paid before any payments can be made the
ordinary shareholders.
24
c) Redeemable Preference Shares

These are shares which carry a fixed rate of interest not a fixed rate of dividend They
are so called because they can be bought back by the company when the need arises.
Therefore, the company can still hold a claim on it within a stated period of future date and
price.

Generally, preference shareholders have very little or no say in the management 01 the business
because the risk they bear is small. However, in crisis situation, they may have some voting
rights at AGMs in accordance with the rules and regulations in the article of association.

3) Debentures or Loan Capital

Debentures are loans for which their holders receive a fixed rate of interest which must
be paid before profits are calculated. Losses made by the company do not affect interest paid
to debenture holders. This means that the interest paid to debenture holder is considered as an
operating expense. The debenture holders are creditors to the company and not
shareholders. They have no ownership or voting rights. They bear very little or no risk. It is

a source of long term long like shares, but the payment of interest on Obligatory. Failure to
honour interest payment can attract considerable pressure from creditors or court action. A
debenture is a kind of an I OU (I owe you).

Types or classes of debentures

Mortgage debentures

These are loans which are secured by definite assets of the borrowing c o m p a n y , that in
case of default) such assets could be sold to pay the creditor or debenture holder.

Naked Debentures

These are loans to a company? Which are not secured by any specific assets of till
company? In case of default, only court action can be taken by the creditors. These kind' of
debentures are hard to come by.

Redeemable and irredeemable debentures

Redeemable debentures have specific dates and prices for reimbursement to holders while
irredeemable debentures are debts that remain part if capital until then, company goes into
liquidation before they are reimbursed.

25
 Convertible and non-convertible debentures

Debentures are convertible if the holder has the option to convert them into ordinary shares at
a given time and non-convertible when they remain as debts.

The Difference between Long Term and Short-term Finance

- Short-term finances are contracted for the acquisition of current assets while long term finances
for the purchase of fixed assets.
- Short-term finances can be obtained from the money market while long term finances are
obtainable from the capital markets
- The interest payment on short-term finance is smaller than for long-term. This is because of
greater risks and uncertainties with long term sources.
- Short term finance must be reimbursed within one year while long term can last for periods
greater than 10 years.
- Short term finance is required for temporal investment projects while long term finance is
required for permanent investment projects like expansion of plants machinery .

Debts versus equity financing

There are some important decisions that must be made when starting a business in terms
of financing For instance) how should the business be financed? What should be the
composition of the capital structure? Should it be more debt or equity financing?

The answers to these questions will depend on the relative merits and demerits of each source.

A) Debt Financing

This type of financing requires the firm or company to pay a fixed interest periodically
to the lenders. Most debt instruments have specific maturity periods. In case of liquidation,
their holders have the first claim on company's assets. This means that their holders hear
very little or no risk. The employment of debt financing in a company) s capital
structure, brings about a financing leverage the use of fixed charge items with the intention of
increasing the potential returns to the firm. There are two types of leverages: A financial
leverage and an operating leverage. Financial leverage is indicated in the liability side of a
Balance sheet while the operating leverage is indicated on the assets side of the balance sheet,
it shows a
reflection of the extent to which fixed assets and fixed costs are utilised in the company while
the financial leverage is a measure of the amount of, debts used in the capital structure of the
firm.
26
 Debt financing instruments

- Debentures, are long term loans

- Mortgaged bonds are secured loans tied on specific fixed assets of the company. They can
either be closed-end bonds, open-end bonds or income bonds.
- Convertible bonds are securities that can be changed at the instance of the holder into
ordinary shares of the company.
- Zero-coupon bonds: 'These are bonds which do not earn interest. But, they are sold at a deep
discount below the face value.
- Irredeemable or perpetual bonds: They are bonds which have no maturity or due date,

Advantages of Debt Financing (Financial Leverage)

- Interest payments are considered as an operating expense, thereby reducing the taxable income
- The use of debt financing up to a reasonable point, reduces the cost of capital to the company.
- The financial obligations to the company are specified and of a fixed nature. This encourages
efficiency in the management of cash and other resources.
- In ease of liquidations or insolvency, debt holders are. first claimers on the company
assets before preference and ordinary shareholder respectively.
- During period of inflation the burden of debts repayment is reduced.

Disadvantages of Debt Financing

- High risk to the company when enough profits are not earned. Creditors may force the company
into liquidation.
- They exert pressure on management in the formulation and implementation of policies which
favour them. Dividend payment of equity holders becomes volatile Of unstable,
- In periods of low profits the company is vulnerable to a takeover as equity holders may be
tempted to sell their shares.

Equity Financing

This is financing a company to a large extent with ordinary shares (common stocks) and to a
lesser extent with preference shares (participating) it is called injected capital because it
is the capital used to start the company by the promoters. Equity holders are the real owners
of the business and manage the business through

Advantages of Equity Financing

- Equity financing gives tight to holders to take part in management

27
- In periods of booms, their holder enjoy a high rate return per share
- Management is not over-burdened by creditors with interest payments
- Equity holders can freely transfer their shares on Ute stock exchange market because such
shares do not carry a fixed date of maturity.

Disadvantages of Equity Financing

- Holders of equity shares bear the highest level of risk in the company.
- In case of liquidation, their holders are the last call on the company's assets,
- The dividend paid on equity shares is very volatile and depend on residual profits. This explains
why their holders are called residual claimants.

Differences between Shares and Debentures

- The risk on shares is higher than on debentures

- Shareholders are owners of the company while debenture holders are creditors
- Shareholders earn dividend while debentures earn fixed interest
- Shares are part of the authorised capital of the company whole debentures are loans
- Dividends on shares are paid out of profits hut interest on debentures must be paid whether the
company makes profit or not.

Revision Questions

l) Discuss five main sources of internal financing of a company,

2) What are the relative merits and demerits of this source?

1) Briefly discuss the pros and cons of debt financing.

may be forced into liquidation by creditors when it is in difficulties. Again, the dividend to
equity holders will be volatile - high when more profits are made and very low when the
company earns low profits. This makes the company vulnerable to takeovers.

Low gearing indicates a very comfortable position for the company, as creditors

Will not exert pressure on company management to pay interest, and policies would be
formulated and implemented without stress.

28
CHAPTER THREE: THE CAPITAL STRUCTURE OF A COMPANY

This is the composition of capital used in financing the activities of a company. It is the
ratio between owned and borrowed capital. The nature of the composition will affect the
leverage of the company or the gearing ratio. The capital of a company has two components.
Share capital and loan or debenture capital. Share capital can he separated into ordinary
and preferences shares.

Capital Gearing or the Gearing Ratio

It describes the ratio of a company's debt (loan capital) to its equity (share) capital. Loan
capital refers to funds advanced by creditors (debenture holders) and reference shareholders
at a fixed rate of interest or dividend. Whereas equity (risk) capital describes the capital raised
through the sate of shares, carrying no. fixed rate of return (ordinary shares). Hence, gearing
shows the' relationship between the company's fixed return capital and the risk capital.

This relationship is expressed as:

Gearing Ratio=
debentures+ Preference sha res
orinary shares

From the formula above, we see that the fixed return capital or loan capital is made up of
debentures and preference shares while non-fixed return securities are equity (risk) Capital.

The ratio obtained is an important determinant 'of whether the company is highly
geared or lowly geared.

If the proportion of loan capital is greater than equity capital; the ratio will be greater than
one, which implies that the company is highly geared.

If the proportion of loan capital is less than equity capital; the ratio will be less than one, which
implies that the company is lowly geared.

Implications of Gearing on the Company

High gearing indicates a higher financial leverage or a heavy reliance on debt financing by the
company. This high debt burden increases riskiness as the company’s debt holders do not take
part in the management of the company neither do they have voting rights.
29
An Illustration of Gearing Ratio

Types of security Capital Gearing Ration

5% debenture 600,000 1,000 000 1,600 , 00 2,400,000

2,400,000 1,600 000
4% preference shares 1,000,00 1, 400,000
0

Ordinary share 2,400 1,600,000 2:3 3:2

000

Total 4,000,00 4,000,000 Lowly geared Higly geared

0

Authorized, Issued and Paid-Up Capital

A company’s share capital may not be all raised at once: When issuing new shares, a company
cannot and is not supposed to exceed its authorized share capital mentioned in the
memorandum of association.

a) Authorized Capital or Nominal Capital

It is the maximum amount of share capital that a public company can raise and it stated in the
memorandum of association -- A document which regulates the external of company.

Issued Capital:

It is that part of authorized capital issued out in the form of shares for subscribers to purchase.
e.g. if a company's authorised capital is 50 million frs and it decides to sell shares to the amount
of 40 million francs, then, the 40 million francs is considered as issued capital.

Called up capital

This is the actual amount per share received from the shareholders, when shares are issued.
Consider that each ordinary share has a face of 10,000 frs and 7000 frs is called-up, from the
shareholders, the remaining 3000 frs is known as uncalled capital. The uncalled capital can be
considered as reserved funds, of the company which can be called-up when need arises.

30
Paid- up capital

It is the amount of capital actually contributed by shareholders as shares.

Important terms in capital structures

Nominal Value: The nominal value of a share is its face value. That is, what is

actually written on the share. It is also known as the par value.

Market Value: This is the price at which a share is selling in the market. It can. be greater or
less than the nominal value, It varies daily, depending on the demand and supply
conditions for the share. When the market value is, more the nominal value the share is
said to he selling at a premium. When the market value is less than the nominal value, the
share is said to he selling at a discount.

Dividend, rate of dividend and yield

i) Dividend: it is the return on share

Dividend = Rate of dividend Face Value of the share

ii) Rate of dividend: It is the dividend expressed as a percentage of the nominal or face value
of the share.
dividend on share 100
rate of dividend = x for share
no min al value 1
interest on a debenture 100
rate of interest = x for debentures
no min al value 1

b) Issued capital 75% of authorised capital

75% of 12,000,000

0.75 x 12,000 000 = 9,000, 000

c) Called-up = 70% of issued capital

70% of 9,000,000

0.7x 9,000,000 = 6,300,000 Frs,

debentures+ preference share

d) Capital gearing =
ordinary shares capital

1,000,000+2,000 , 000+1,000,000
=
8,000,000

31
 4,000,000 1
Capital Gearing = =
8,000,000 2

= ½ or 1:2

Hence, the company is lowly geared.

Exercise 2

The financial structure of ABC Company is presented as follows

100,000 7% preference of ABC company is presented as follows

50, 000 8% debentures of 2,000frs

200,000 Ordinary shares of 1,000frs each.

After the payment of taxes, trading expenses and the allocation of reserves, 40 million
Frs is available for distribution.

Required

A. What rate of dividend will be paid to the ordinary shareholders?

B. If ordinary shares are quoted at 800frs each, what is the current yield?
C. Why do you think ordinary shares were issued in such small amounts of 1,00frs

Solution

Ordinary shareholders are residual claimants; they 'can only receive dividend after interest
has been paid to debenture holders and dividend to preference shareholders

8 2000
a) Interest to Debenture holders = x x 50,000=8 ,000,000 F
100 1

7 2000
b) dividend to pref. shareholders = x x 100,000= 14,000,000F
100 1

= 40,000,000-22,000,000

= 90 frs

dividend per Ord . share 100

Rate of Dividend = x
no of min al value 1

90 100
= x
1,000 1

= 90%
32
 dividen per 100
a) Yield = x
200,000 1

90 100
= x
800 1

= 11.25%

b) – To encourage low income earners to buy shares

- To reduce (he financial leverage of the company.

CHAPTER FOUR: THE NATURE OF CAPITAL

Fixed, working and circulating capital

Every business needs funds for two main purposes: For establishment and to carryout daily
operations.

Funds needed for long term purposes to create production facilities, through the
purchase of fixed assets is called Fixed Capital and Funds needed for short term purposes for
the purchase of raw materials, payment of wages and other daily expenses is known as
working capital .

In other words, working capital refers to that part of the firm's capita) which is required
for financing short term investments Of the acquisition of current assets such as; cash,
marketable securities debtors and inventories.

Circulating capital is capital that keeps changing form in the course of business,
e.g., from cash to inventories, from inventories to receivables and book debts, from
receivables and hook debts back into cash. In short, circulating capital is the sum of
working capital and current liabilities. Hence working capital is also known as floating,
circulating or short term capital.

Concepts of working Capital

Working capital deals with the management and .control of current assets and current-
liabilities. Two distinct views may be noted as regards the definition of working capital

1) Networking Capital concept

2) Gross working capital concept

33
I) Net working Capital concept

According to this concept, working capital means the difference between total current assets
and total liabilities.

Net Working capital = Total Current Asset-Total current liabilities

This concept is supported by authorities like Lincoln, Saliers and Stevens.

This concept of working capital helps the investors and creditors of a firm to judge its financial
soundness and its margin of protection. It also helps them to discover the true financial
position of the company. The Networking capital may be positive or negative .

Positive, when CA > CL

Negative, when CL > CA

Current liabilities are debts which must be paid in the ordinary course of a business with.in
a short period, out of the current assets or the income of the business. Examples are: sundry
creditors (bills and Accounts payable), Trade advances (given to the company for
supply goods) short term borrowing from banks and others financial institutions, provision
for taxes, bad debts etc.

2) Gross Working Capital concept

According to this concept, the term working capital refers to the gross working

capital and represents the amount of funds invested in current assets. This view is

supported by authorities like; Field, Baker and Malott. The main merit of this view is that
profits arc earned with the help of assets which are partly fixed and partly current
The main items that comprise current assets are; cash in hand) cash in bank, cash in
transit, short-term investments, inventories, (raw materials, consumable stores, work in
progress and finished goods), Sundry debtors (Bills Receivable or accounts receivable)
loans and advances (given by the company to others).

Gross working capital = Inventories+ receivables+ cash (bank balances)

34
 In practice, working capital management concerns total current assets and total current
liabilities which vary depending on the level of current assets required. The term,
networking capital is an accounting concept, not having much to do with economics
and financial management.

Need of working Capital

The basic objective of financial management is maximization of shareholders'

wealth. This is possible only when the company earns sufficient profits. The
amount Of sales determines the amount of profits. Working capital is required during
the operating cycle in order to sustain the sales activities. Thus, working capital is needed for the

- For the purchase of raw materials

- To pay wages, salaries and daily expenses
- To provide the selling costs like packaging advertising etc
- To maintain the inventories of raw materials, work-in progress and finished goods

Importance of working capital

Working capital is the life-blood of a business. No business can succeed without an

adequate amount of working capital. However excessive working capital represents idle funds
which earn profits for the firm, and inadequate working capital on the other hand
results in production stoppages due to insufficient funds which also bring down the profitability,
hence, adequate working capital is important (or the following reasons:

I) Good running of the business: where there is smooth flow of production without interruptions

2) Goodwill: Prompt payment of suppliers creates a good image for the firm

3) Increase credit worthiness: High solvency and good credit standing of a firm enables. hanks
and other lenders to arrange favourable terms

4) Cash. discounts: sufficient working capital enables the firm to benefit from cash discounts
on purchases and this reduces costs.

5) Increases the confidence investors: with sufficient working capital, there is quick and
regular payment or dividends to investors. This creates a favorable market to raise additional
funds in the future.

35
1) Ability to face crisis: adequate working capital enables the firm to face crisis much effectively
without undergoing any sort of pressure from creditors .

Working Capital Cycle

The working capital cycle Of operating cycle refers to average time that elapses between the
acquisition of raw materials and the final cash realisation from sales. The operating cycle
consists of four stages;

a) The raw materials and store inventory stage

b) The work-in-progress stage

c) The finished goods inventory stage

d) The receivable stage

Representation of operating cycle

cash

cash
Raw material
inventory

Finished goods

Work- in progress

Determinants of working Capital

36
 The working capital requirements of a firm are constantly affected by the crisis crossing
economic currents flowing about the business, The nature of a firm' s activities, the economic
health of the Country) the state of economic situation are all part of these shining forces.
It is difficult to rank them because all these factors are

of different importance and the influence of an individual factor can affect changes in the
firm over time. However, the following are important factors:

1) Nature of business

A company’s working capital requirements are basically related to the kinds of

Business it: conducts. Public utilities need very limited working capital because they

offer cash sales only and supply services, Hot products. Trading enterprises
have invest proportionately high amounts in current assets as they have to carry stock
trade) accounts receivable and liquid cash. The industrial units also require it large
amount of working capital, though it varies from industry to industry, because of the
lack of uniformity in the asset structure of various industries. Generally
speaking, trading and financial firms require relatively very large amount, public
utilities comparatively small amounts, whereas manufacturing companies stand between
these two extremes, their needs depending upon the character of which they are a part.

2) Production Policy:

Strong seasonal variations result in special working capital problems, in

controlling the internal financial swings that may take place. In such cases, the
requirement of working capital depends upon the production policy. The choice rests
between keeping the production steady by accumulating inventories and curtailing the
production during the slack season and increasing it during the peak season. In the former
instance, the uniform manufacturing rate minimizes fluctuations of production schedules
hut enlarged inventory creates special risks and costs. In the latter case) inventories
are kept at minimum levels but the production manager has to shoulder the responsibility of
constantly adjusting his working staff. Thus, it is obvious that a firm require working capital
if the policy is to keep production steady by accumulating inventories.
37
3) Manufacturing process:

In the In the manufacturing business, the working capital requirement l~ directly

proportionate to the length of the manufacturing process. The longer it takes to make
products and the greater its cost, the larger the inventory tied up in its manufacture with
progressive increment of labour and service costs before .the finished product is fully
obtained. Therefore, if there are alternative processes of production in the
manufacturing process, the process with the shortest production period should be chosen.

4) Growth and expansion of business:

As the composition of working capital is growing, companies also shifts with economic
circumstances and corporate practices, growing industries require more working capital than
those that are static, other things being equal. However, it is difficult to determine
the relationship between the growth in the volume of business and the growth in the working
capital of a business.

5) Seasonal variations

Tile raw materials of certain industries are not available throughout the year. In
such cases) the firms have to purchase the raw materials in bulk durill9 the season to
ensure uninterrupted now, and process them during the entire year. Due to this) a huge
amount gets blocked in the form of material inventories during such season, giving rise 10
more working capital requirements. Thus, it can be concluded that a firm requires,

larger working capital during the busy season than in the slack season.

6) Dividend Policy:

The dividend policy of a firm also influences the requirements of its working capital. A firm
that maintains a steady high rate of cash dividend irrespective of its generation of profits
requires more working capital than the firm that retains larger part of its profits and does not
pay so high rate of cash dividend.

Capital owned and capital employed

- Capital owned

38
Capital owned is the amount of money invested in the business by the owners. The money is
used for the acquisition of fixed assets, materials and the daily running of the enterprise. It
consists of the Total capital or (FA + CA - CL)

Where: FA= Fixed Assets

CA= Current Assets

39
 CL= Current liabilities

- Capital employed

It represents the amount of capital actually used in the business. It includes:

Fixed Assets +working capital-debtors

Capital Employed= FA+(CA-CL)-Debtors

Where FA= Fixed Assets

CA= Current Assets

CL= Current Liabilities

NB: Debtors are excluded because; it is money outside the business.

Application exercises

Consider the Balance sheet of Muma Enterprise below

Balance sheet as at 31st December 2009.

Assets Liabilities + capital

Items Amount Items Amount

Fixed asset: Capital 8,000,000

Buildings 4,000 000

Equipment 2,000,000

Motor van 1,000,000 Current Liabilities:

7,000,000 Sundry creditors 1,400,000

40
 Current assets: Trade advances 600,000

Inventories 1,500,000 2,000,000

Debtors 500,000

Bank 700,000

Cash 300,000

3 000 000

Totaal 10,000,000 Total 10,000,000

Determine;

a) Capital owned
b) Capital employed

Solution

a) Owned capital = 8,000,000 as on the balance sheet OR

= FA + (CA-CL)
= 7,000,000 +(3,000 000 – 2,000,000)
= 7,000,000 +1,000,000
= 8,000,000frs
b) Capital employed = fixed assets + working capital-debtors
But, working capital= CA-CL
= FA+(CA-CL)-Debtors
= 7,000,000 +(3,000,000-2 000,000)- 500,000
= 7,000,000+1,000,000
= 7,500,000
Terms related to capitalization
a) Over capitalisation

This occurs when the returns of capital invested are unable to provide adequate profits to
shareholders. This may be caused by inefficiency is management due to a mismatch in the
sources and uses. E.g. heavy investment in 'fixed assets and small working capital.

b) Under capitalisation

41
 This occurs when the profits indicate a higher return on capital invested. This is as a
result of under estimation of profits in planning, good economic conditions, prudent
management or good choice of investment projects.

Sales and profits

a) Gross Profits

This is the amount of profits made by a firm before any deductions are made.

Include, selling expenses and other overheads incurred by the business.

Gross profit = Sales-Cost goods sold

But COGS = Purchase + Opening Stock-Closing Stock

b) Net Profit

It is the profit left after other expenses have been subtracted from gross profit.

i) Net Profit (before tax) = Gross profit-other expenses except COGS

ii) Net profit (after tax)= Gross Profit-other Expenses)

The determination of Gross profits and nets profits is done with the use of the profit and loss
account or the income statement

c) The profit and loss account

The profit loss account (P/L) shows the sales and revenue and other incomes for the
period. It shows the calculation of the gross profit and Net profits.

42
 Application exercise

Use the information provided below to prepare a P/L statement showing Gross profit, Net
profit before tax and net profit after tax.

Sales for the period = $1.000,000

Opening stock $100.000

Purchases made during the period = $300.000

Unsold stocks t the end of the period= $ 50.000

Rent paid during the period= $70.000

Salaries = $90.000

Transportation and other expenses = $40.000

Income tax rate =30%

solution

profit and loss statement

Amount Amount Amount

Sales 1000 000

Opening stock 10,000

Purchases 300.000

Less closing stock (50.000)

COGs 350.000

43
 Gross profits 650.000

Less expenses:

Rents 70.000

Salaries 90.000

Transportation 40.000 200.000

Net profit before tax 450.000

Less tax at 30% (135.000)

Net profit after tax 315.000

Explanation of table;

Purchase = $300.000 sales = $1000.000

Opening stock +$100.000

Closing stock-$50.000

C.OG.s = $350.000

Gross profit =$650.000(sales-C.O.Gs)

Other expenses

Rents = $70.000

Salaries = $ 90.000

Transport and other expenses = $40.000

$200.000

Net profit before tax = $450.000(Gross profit-other expenses)

Income tax rate = 30% of net profit before tax

= 30/100x 450. 000 = $135.000 as tax

Net profit after tax = $315.000(gross profit-tax and other expenses)

44
 The Cash Budget ;

The cash budget forecasts the inflows and outflows of cash in a firm. It shows the receipts,
payment and balances at the start and at the end of the period .

 The receipts are sources of cash such as: operations (credit and cash sales)
 Loans, share capital, sales of fixed assets, reduction in stocks and reduction in debtors

The payment are uses of cash such as:

- Purchase of raw materials Repayment of loans

- Purchase of fixed assets
- Purchase of finished goods
- Reduction in creditors (suppliers) Payment of wages and salaries

Presentation of a cash Budget

AMINO’S

Cash Budget for the year ending 31/12/2010

Items Quarter 1 Quarter 2 Quarter 3 Quarter 4 Totals FCFA

45
 FCFA FCFA FCFA FCFA

Opening 18,000 48,000 50,000 80,000 18,000

Balance

Receipts; 240,00 252,000 300,000 248,000 1,040,000

Debtors

Total 258,000 300,000 350,000 328,000 1,058,000

Payments 150,000 180,000 200,000 140,000 670,000

Wages

Other 20,000 20,000 30,000 50,000 120,000

expenses

Purchase of 40,000 50,000 40,000 60,000 190,000

materials

Total 210,000 250,000 270,000 250,000 980,000

Closing 48,000 50,000 80,000 78,000 78,000

Balance

Note: The closing balance of quarter 1 is the opening balance of Quarter 2. The difference
between total and the total payments gives the closing balance for each quarter.

CHAPTER FIVE: MONEY AND CAPITAL MARKETS

The money markets

These are markets for short term and medium term funds. It consists. of all banks and
financial institutions that deal in short term loans, or borrowing lending. It is

46
 precisely a market for short term loans and investments, The primary function of the money
market is to ensure that the necessary tools or facilities are provided to regulate Money supply;
hence the money market serves as a central pool of liquid financial asset or resources upon
which it can make payments when it holds surplus funds. It is also provides the necessary
regulatory mechanism through which the liquidity of the banking system is maintained.

In this market borrowing and lending of short term funds can vary form one day to

one year, we also have the buying and selling of short term financial instruments such as; bills
of exchange, treasury bills, certificates of deposit, etc.

Participants or financial institutions operating in the money market include the central hank
(which controls the markets) commercial banks (which are the chief lenders That supply the
fund) the discount houses which deal with treasury bill, bank hill and trade bill of exchange),
Merchant bank and accepting houses (which also deal in bills, by, accepting them) and hill
brokers. The London Money market is arguably the most organise in the world, Sadly) we
have a dysfunctional money market in Cameroon which is poorly organised.

Financial institutions in the money Market

1) Discount Houses

A discount house is a financial institution which specialises in discounting a variety of

bills, such as treasury bills, bins of exchange .and other bills issued by the government,
commercial and industrial corporations or companies, The discount houses hold the
securities and present them to the central bank, commercial banks or accepting houses. Their
main function is to .act as a, bill broker by arranging the sale of bills.

between two parties and receives a .brokerage for their services. They also buy bills
endorsed by accepting houses. Furthermore, they convert future credit into present cash.

2) Accepting Houses

They deal with bills of exchange. It is a financial institution that specialises in accepting"
bills by endorsing them with the name and stamp of the house. Such an
acceptance, guarantees payment" of the bill by the acceptance house should" the drawee
default payment. A fee is charged for these services provided. Its main functions are
accepting bills of exchange, endorsing bills using its name and stamp, guarantee the payment
of debts and encourages international trade.

3) Clearing Houses
47
 A clearing house is a financial institution where inter-bank indebtedness is settled. Cheques
drawn by bank A could be cashed in bank B and the resultant claim of each bank on the other
bank can be settled by the clearing house, Hence) the main functions of the clearing houses are:

- settlement of inter-bank debt

- returning of dishonourable cheques
- transmission of cheques and other documents
- secondary Money Markeys (Parallelle)

Secondary Money Markets (parallel)

These are institutions which carry inter-bank lending and borrowing within the money
market. They are short term sources of finance. They have a higher level of dealings than
those in discount houses and others. They include:

1) Inter-Bank Market

Where commercial banks" borrow and lend to others e.g. LIBOR (the London
inter-bank offered rate of interest). The rate in this market changes depending on the

demand for liquidity.

2) Inter-Company Market
Here, one company can borrow from another directly or through a bank
3) The Euro –currency Market

It is also known as the Euro-Dollar market Euro. currency is the name given to any currency
which is borrowed and loaned outside the country which issued the currency. The Euro .D.
ollar market is the market for lending and borrowing of the USA Dollar outside the
United States. This market is said to have started during the cold war days, when the
fanner USSR did not want to invest its holdings of the US Dollar in the United States.

Functions of the money market

 It serves as a pivot or central pool of liquid financial resources

 It allocates savings into general investments in such away that it tries to balance the liquidity
of the banking system at a desired level

 It promotes the liquidity and safety of financial assets in safe environments

48
 It promotes financial mobility by facilitating the transfer of funds from one sector to another.
 It brings together buyers and sellers of securities.

The capital Market

It is a market for long term and medium term funds to businesses and the governments,
It can also be called a market for permanent and long term loans or a market for investment
capital. It is a market for those who need capital for heavy business or projects such as; road,
factory buildings and oil refinery constructions. As the central bank is the pivot of the
money market, the stock exchange is the pivot of the capital market. Apart from the stock
exchange, the other institutions of the capital market include; insurance companies,
investment banks, building societies, issuing houses etc.

The capital market is made up of the inner capital market and the outer capital

market.

The inner capital market

It consist of; merchant banks, company promoters, underwriters, unit ~trust, investment
trust, bill brokers and the stock exchange. This is a market for new securities which directs the
flow of funds from holders to lenders.

The outer Capital Market

It consists of building societies, insurance companies) mortgage banks, saving banks, pension
funds etc. which deals in long term bon-owing and lending.

Institutions of the Capital Market

1) Investment Bank

This is a bank that provides long term fixed capital to limited companies by buying shares in
them. Its main functions are; underwriting, (which is a guarantee to a company to buy i t s
remaining issue of shares, not subscribed by the public.) portfolio management (managing
funds of institutional customers in need) equipment leasing etc.

2) Merchant Banks

They specialise in the provision of medium term financing and their activities differ from other
banks, but similar to those of acceptance house, They are experts in the capital . market a n d
are sometimes called acceptance houses. Their main f u n c t i o n s include; assistance
provided to public companies to issue new shares and raise additional capital. They also accept

49
 hills of exchange and undertake to pay the discount house, if the debtor or importer default
payment on maturity. They also underwrite shares like investment banks. Lastly the provide
financial and technical advise to investors on matters related to investments.

3) Issuing Houses

They perform the function or rule of sponsoring companies capital issue and the sale of
securities to the public. Their main functions include:

- portfolio management
- equipment leasing
- corporate financing etc.
4) pension funds

These are institutions whose funds come from industrial and commercial

enterprises, which arc legally required to make deductions from their

employee salaries and deposit the amount deducted with the pension fund. The pension
fund can use these funds to buy' securities in other companies or government bonds.
Huge sums of money are regularly available from pension funds which can be used to
finance the deficit spending of other institutions.

5) Building societies or mortgage Banks

Building societies are financial institutions that accept deposits and the funds to provide
long term loans for building houses on mortgages. They encourage members to have
their own houses. They are essentially non-profit making and aim mainly to facilitate
home ownership and thrift amongst people with modest means.

Functions of the Building Societies;

- The provision of long term housing loan

The acceptance of deposit from members of the public encourages the growth of industries
which produce building materials.

6) Insurance Companies

An insurance company is a financial institution whose primary function is to receive

premiums and enter into contracts with individuals and organisation to insure them with the
purpose of paying compensation for the insured, if they suffer certain losses in the future.

50
 The role of insurance Companies;

- Pooling of risk the insured pay premiums which are pooled i n t o a fund used to
compensate those who have suffered losses.
- Provision of capital to industries. They buy, shares in companies..
- Facilitates or boost the expansion of commercial and industrial activities. Investors are
encouraged to expand, because their investments are covered with a policy.
- Provision of investment advice: they provide managerial and financial advice to investor.
- Direct investment: they undertake investments 111 the productive sectors of the economy.
7a) Investment Trusts

They are limited companies formed, registered in the usual way of registering a company. But
they exist solely for the purpose of holding shares in other companies. As one buys shares in an
investment trusts, he is indirectly investing in a large number of different companies. The
dividend is the income to the investment trusts, which, is in tum, paid as dividend to its own
shareholders. Shares of the investment trusts can only be sold in the stock exchange market and
not back to the trust.

7 b) Unit Trust

A unit trust is very similar in function to the investment trusts and it is a business operated with
the aim of attracting small investors to buy "units" in the trust. This enables them to buy and
hold stocks and shares of many companies. Expertise managers do the investment in the shares
and bonds. The investors in unit trust are entitled to a share of the returns on the invested
funds. Shares in a unit trust can only be resold to the trust and not in the stock exchange
market. The unit trust is a trustee business. Its deed defines the responsibilities of two parties.

The Trustee: A well known bank or insurance company, responsible for the safe' keeping of
securities of the trust and for ensuring that the agreements of the trust are respected.

The management company: It is the one responsible for the purchase and sale of the securities
and for the day-to-day management of the affairs of the trust.

Comparison between a Unit Trust and an Investment Trust

Differences;

- The unit trust is a trustee business managed by specialists while the investment trust is a joint
stock: company and a registered company.

51
- The shares of a unit trust can only be resold to the trust while the shares of an investment trust
can only be resold privately in the stock exchange market.
- The capital or a unit trust is not fixed but the capital of the investment trust is fixed.
- Unit trust limits its investment in particular industries when buying shares) but the investment
trust spreads its risk in many investment areas. There is diversification of resources.

Similarities

- They both have specialists company management or managers

- They are all institutional investors
- Their aim is prom maximization
- They provide 'capital to other business by buying shares

8) Development Banks

A development bank is a financial institution specialised in the provision of long .. term capital
for investment in specific productive areas of the economy such as industry, agriculture,
commerce) etc., e.g, the former credit agricole, the national Investment Corporation (SNI).

Their main functions are:

- provision of long term capital for investment in industries, agriculture etc.

- offer financial and technical advice to investor
- conducting studies or research in the economy to help investors
- They help to reduce unemployment by providing small businesses with long-term loans.

NB: These institutions are also known as Institutional Sources of Finance.

Functions of the Capital market

. It facilitates t h e flow of funds from those who have to those who need. It: is a market for
the issue of new securities (primary capital market) Large sums of money can be raised
52
and for longer periods of time.

It helps to convert illiquid assets easily to liquid assets thereby encouraging people to invest in
companies.

It permits the state to raise heavy sums of money for huge investment projects, like

in road construction, wars etc.

CHAPTER SIX: THE STOCK EXCHANGE MARKET

Introduction and Definition

The stock exchange is a highly organised financial market for dealings in stocks and shares. It
is a, market for existing financial assets or securities like shares, debentures and other securities
53
 issued by the public authorities. It also provides facilities for issue and redemption of
securities and other financial instruments, and capital events including (he payment of
income and dividends. The stock exchange itself does not raise new capital but only
helps indirectly to raise the new capital by providing the means through long-term and
unredeemable stocks and shares can be transferred. Most of the securities traded are issued
by companies, unit trust, governments etc. such 8S; derivatives, pooled investment products
and bonds.

The initial public offering (IPO’s)of stocks and bonds to investors is by definition done in
the primary market and subsequent trading is done in the secondary market. Hence, it is
therefore a market for old securities and companies can raise new capital by issuing shares
and stocks in the primary market,

To sell securities on (he stock exchange market, the company must be listed on the exchange.
The conditions for listing differ from market to market. The most popular stock markets
include: The New York Stock Exchange (NYSE), Financial Times stock Exchange
(FTSE) in Loudon, 'Toronto: Stock .Exchange, National association of Securities
Dealers' Automated' Quotation System (NASDAQ) - the world's first electronic
stock-exchange, CAC 40 ill Paris, Frankfurt and Amsterdam Stock Exchanges, Tokyo,
Lagos, Douala etc.

Conditions for listing on the stock exchange

To have a company listed on the stock exchange, it has to satisfy a number of conditions and
follow procedures which can be expensive and include the following;

- The company must have been in existence for a number of years before application can be
accepted (Duration determined by each stock exchange market).
- A sizable number of shareholders must exist for the company (determined by the exchange)
- The listed company pays some fee to the stock exchange authority on regular basses.

Advantages of Listing;

- Permission to buy and sell securities on the stock exchange,

- Increase in marketability of the company's securities
54
- improves the image of the company

Disadvantages of Listing

- Listing may facilitate the takeover of the company by a competitor

- The procedures for listing are lengthy and expensive

Dealers or Members of the Stock Exchange

Business on the stock exchange used to take place between jobbers and brokers.

Jobbers: They are the main dealers on stock exchange floor. They deal with

stocks and shares issued by government and companies. Their transactions were limited with
brokers and they had no contact with the general public. They relied on profitability

of shares bought from brokers at lower prices and sold in the market at higher prices.

This is how they used to operate;

The jobber quotes two prices. The bid and offered prices, which represent the

buying and selling prices respectively.

The difference between is the jobbers commission or profit known as the jobber's turn. The
jobber’s price list of stocks may be in blue or ted. A blue stock indicates a rise in price while a
red stock shows a fall in price, With these prices, no further bargaining by brokers and investors
is allowed. Reason, in the stock exchange a man’s word is his bond or ‘Dictum meum pactum’.

Brokers: They agents with direct public dealings. They link investors who wish to buy or sell
securities with the jobbers. They follow the instruction of the client's and act on behalf of the
public - clients wishing to buy or sell securities. They buy shares at lower prices possible and
sell to jobbers and the public at higher prices. The charge a commission for their services called
Brokerage.

Speculation i n the Stock Exchange Market

55
Dealings or transaction in the stock exchange is fuelled by speculators who buy or sell securities
an anticipation of a rise of a fall in price to make profit. These speculators include:

1) Bulls: Speculators who buy shares hoping that prices will rise for them to sell at higher
prices and make, a profit.' Usually, they buy without making immediate cash payment.
Settlements are done before the closing bells. If prices do not rise as expected or fall, he pays
the difference to the jobber known as contango

2) Bears: Speculators who sell shares which they do not possess, in the hope that the price win
fall so that they can then buy them back at a lower price ,to make profit. However) if prices
rise instead of fall, they pay the Jobber from they took the shares the difference. This charge is
called backwardation.

J) Stags: Speculators who buy new shares with no intention of retaining them, but in the hope
that prices will rise so that they can sell them at a profit.

4) Options: It is a right given to some speculators to buy or sell within a stated period, a
definite amount ofa specific security at a price fixed when purchasing the option known as the
"sinking price", There two types of options: A "call" and a "put' option.

A put option is the right to sell specific securities and a call option is the right to

buy specific securities. The right to sell (put) and buy (call) at the same time is called a
f
"Double option." When the stock exchange is dealing with new securities, it is known as the
primary market but when the dealings is in old securities; already issued by companies,
it is a secondary market.

Developments in the Stock Exchange Market

Securities market took centuries to develop, The idea: of debt's dates back to the ancient: world,
'as evidenced by clay tablets recording interest-bearing loan .in ancient Mesopotamia.

In 1979, the British government opened up the economy and increased the level of competition,
the payment of a fix commission to' brokers was seen as a monopolistic practice. In the same
year, the American government abolish the fixed commission payments in the New York
Stock Exchange, making cost for British institutions dealing in New York to be lesser than ill
Britain itself.

56
Furthermore, ,the introduction of electronic and modern communication system meant that
changes in securities prices in one part of the world could be transmitted and indicated
visually on screens in other Centres. This meant that there was no need for Jobbers and brokers
again. Pressure was then put on the Britain Stock Exchange authorities to revise its
fixed commission arrangement The change took place on the 27 th October 1986 and produced
an immediate upheaval in financial markets all over the world and this is commonly referred to
in stock exchange language as the "Big Bang."

Today, dealings on the stock exchange are no longer the "floor of the house?' as it used to be.
There is now the stock exchange automated quotation system (SEAQ) which is actually the
electronic market place. Information on prices and deals made are fed directly into the SEAQ
and displayed on screens. The market ..makers then quote the selling prices (and a lower
buying price. The new prices are then recorded on the SEAQ screen for the rest of the market.

Usually, there is a central location for recording keeping) buying and selling like the New
York Stock Exchange. There is also the over-the-counter market where; dealers at
different location trade through computers and telephone networks e.g, NASDAQ. Such
trading is said to be off exchange or over-the-counter.

Indexation and Quotation on the Exchange

Market indices are used in measuring the investment performance of the overall market
Investors can choose from an enormous number of different securities. For example) about
1300 companies are listed on the London Stock Exchange. More than

4000 common stocks are traded daily on NASDAQ stock matter by a Network of dealers.

Against this background, financial analysts cannot track every stock, so they rely on market
indices to summarise the returns on different classes of securities. The best known stock
market index in the United States is the now Jones Industrial Average commonly known as
Dow.

How trading and quotation are done on the stock Exchange Market

Suppose DOW starts the day at a value of 9000 and the rises 90 points to a new value of 9090.
Investors who own one share in each of the 30 large companies in DOW makes a capital gain
of:
57
 change∈index value 100 90 100
Capital gain /Loss= × = × =0.01∨1 %
initial Index Value 1 9000 1

Consider the following illustration showing the end of day values (indices) on the
London Stock Exchange Market commonly called the Financial Times Stock Exchange
(FTSE) .

End of values

Name Prev. close Value +/- %+/- Direction

FTSE MID 250(ex IT) 10,300.38 10,346.36 +46.48 +0.45

FTSE 350 HIGH Yield 2,977.85 3,004,34 +26.49 +0.89

FTSE 350 LOW Yield 2,407.28 2, 433.30 +26.02 +1.08

FTSE 350 (exit) 2,821.42 2,849.47 +28.05 +0.99

FTSE All-share (exit) 2,750.17 2,776.82 +26.65 +0.97

Data provided by Proquote

Other market indices include standard and poor’s composite index(S &P5000) USA, NIKKEI
Tokyo Japan etc.

Functions of the stock Exchange Market.

The stock exchanges perform multiple functions in the economy and this includes the
following.

1) Raising capital businesses: It provides companies with the facility to raise capital

for expansion through selling shares to the investing public.

2) Corporate governance: With s t r i n g e n t rules imposed by the Stock Exchange,

.companies tend to improve management standards a n d efficiency to satisfy the demands of

shareholders) and other stakeholders. Hence, public companies listed on the stock exchange
have-better management records that privately owned companies.

58
3) Creating Investment opportunities for small investors: The stock exchange provides
the same opportunity for small investors to own shares in the .same companies as large
investors.

4) It provides a market where those who wish to make money can buy shares or
securities and those who which to claim their money can also-sell on terms acceptable to all.

5) Securities prices are displayed on the SEAQ screen, thereby enabling investors to

follow opinions regarding companies ill which they want to invest and to channel their funds
into profitable enterprises.

6) The public is also protected against fraud since any company which sell shares in the Stock
Exchange must make its credentials known to the public.

7) Through the daily display of prices for various shares; serves as a barometer tor the
measurement industrial and commercial efficiency since price movements reflect commercial
success.

8) Securities are made liquid, since the Stock Exchange is an assembling place for buyers and
sellers. This enables people to lend to industries and to the governmental

Securities traded in the Stock Exchange

1) The Gift- Edged Securities: which are securities issued by the government and the carry a
fixed rate of interest.

2) Local Authorities and .other public loans: They are similar to Gilt Edged except that they
.
are issued by the local authorities.

3) Debentures: They are forms of IOU since they are not shares but a kind of loans with a
fixed interest. The holder of debentures is a creditor to the company.

4) Shares which include ordinary preference shares

5) Bonds which are financial assets created by some type of loan, include; term bonds same
maturity period, serial hands-different maturity dates; issued by companies or the government

59
Factors affecting Security Prices in the Stock

1) Industrial relations: Where there are strikes in an industry, people will not be willing to
buy the shares in such an industry and its share prices will fall.

2) The growth prospect of the company: Where there is a high prospect for growth in the
company, this will attract more investors and share prices will rise and vice versa.

3) Mergers and takeover bids, i.e. mergers and takeovers firms usually offer generous

terms to shareholders of the approached company causing the prices of its shares to rise.

4) The recent profit record of the company, especially the recent rate of .dividends to
shareholder.

5) Government economic policy regarding taxation of profits, monetary policy on

Interest rate determination and government spending .These p o l i c i e s will affect share

Prices positively or negatively.

Methods of Disposal o f New Issues in the Stock Market

a) The public issue: This is the case where the company issuing the shares makes a
direct approach to the general public The shares are issued through the issuing house

, which is a specialised institution for the issuing of new shares. The issuing house decides
on the shares to be offered, the price of each share, the rights they carry which are
entered into a prospectus prepared by the issuing house. The prospectus is then
advertised in newspapers and a copy filed with the Registrar of companies, If the shares are
oversubscribed, then the issuing house must allot to the applicant a proportion of the
shares subscribed. If undersubscribed, the issuing house will be left with unsold shares, which
are given to an underwriter, if such unsold shares were guaranteed by the underwriter.
The underwriter is a specialist firm which acts like an insurance guarantor and take up unsold
shares for a commission.

b) Offers for sale: This is the case where all the shares are sold to the issuing house, which
then offers the shares for sale to the general public. This method also requires the preparation of

60
a prospectus by the issuing house.

c) Placings: This is where the issuing house acts like a broker does; not offering for sale

the shares to the public but instead places them, by contacting institutions like insurance
companies, stock exchange and getting them to accept large blocks of shams on offer.

d) A rights issue: This is a method where the company writes to its existing shareholders
giving them the chance of buying new shares ill proportion to their existing, shares) i.e, as
shareholders, they have "fights to a number of new shares. The shares are offered to them at
less than their current market price

e) Issue by tender: with this method, subscribers are asked to nominate the prices which they
are prepared to pay and the shares are sold to the highest bidders. This is because it is often
difficult. to estimate the true market value of new shares when trying to fix the issue price.
This method has the advantage that it brings into play market forces of demand and supply.

61
62
CHAPTER SEVEN: INVESTMENT DECISIONS (CAPITAL BUDGETING)

Definition of an Investment

Investment is the flow of expenditure devoted to projects which produce goods and services for
immediate consumption. Investment may take the form of physical or human capital as well
as inventories or stocks. We are more concern here with capital investment, which refers to
the creation of capital goods or goods which assist in further production. This is opposed to
human investment which is concerned with the acquisition

of skills and capacities that can improve on the productivity of human beings. There are

several types of investments but in this chapter, we are concern with capital investment which
is one of the main components of aggregate demand.

A capital expenditure may be defined as an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of years
in future. The capital expenditure decisions of a firm therefore, usually involve large
sums of money, have long - time spans and carry some degree of risk and uncertainty.
The planning and control .of capital expenditure is termed as capital budgeting. In other words
capital budgeting is the art. of finding assets that are worth more than they cost,
to achieve a predetermined goal, i.e., optimizing the wealth of a business enterprise.
Thus) the capital budgeting decisions are decisions as to whether or not money should be
invested in long - term projects. It includes analysis of various proposals regarding capital
expenditure to evaluate their impact on the financial situation of the company and to
choose the best out of various alternatives. The function of finance in this area is to enable
the management to take a proper capital budgeting decision.

Capital Budgeting Process

The capital budgeting process is very complex; H involves decisions related to the
investment of current fonds for the benefit to be achieved in the future. The capital
budgeting process is as follows:

(i) Project generation

(ii) Project evaluation

(iii) Project selection

(iv) Project execution

(v) Performance review.

63
(i) Project generation: The capital budgeting process starts with the identification of
investment proposals to be undertaken depending upon the company' s future plan of
activity

The proposals about potential investment opportunities may originate from the top management or
may come from any officer of the organisation. The departmental heads then analyses the
various proposals and groups them according to the following categories ..

(a) Replacement of equipment: The existing out - dated equipment and machinery can be
replaced by purchasing new and modem ones.

(b) Expansion: By purchasing additional equipment the company eau increase its
product lines.

(c) Diversification: The Company can produce various products and diversity its product lines.

(d) Research and Development: By this the company can incur heavy expenditure with a view
to innovate new methods of production, products etc.

(ii) Project Evaluation: The next step in the capital budgeting capital budgeting process is to
evaluate the profitability of various proposals. The process of project evaluation comprises two
steps.

(a) Estimation of benefits and costs: These must be measured in terms of cash flows.

Benefits to be received are measured in terms of cash inflows and costs to be incurred
are measured in terms of cash outflows.

(b) Selection of appropriate criterion: There are many methods to evaluate the
profitability of various proposals. The selection of an appropriate method to judge desirability of
the project is also a step in project evaluation. However, it should be noted that the various
proposals to be evaluated may be classified as

(1) Independent proposals

,{2) Contingent proposals

(3) Mutually exclusive proposals.

Independent proposals are those which do not compete with one another and the same
may be either accepted or rejected on the basis of a minimum return on investment required.
The proposals whose acceptance depends upon the acceptance of one or more proposals

64
are the contingent proposals. Mutually exclusive proposals are those which compete with each
other and one of those may have to be selected at the expense of the other.

(iii) Project selection: After evaluating various proposals, the unprofitable or

uneconomic proposals may be rejected straight away. But there is no standard
administrative procedure for approving the investment decisions. Hence, it is very
essential to rank the various proposals and to establish priorities after considering
urgency, risk and profitability involved therein, However, the proposals are scrutinized at
·multiple levels and the final approval of the project generally rests with the top
management of the company. Sometimes the top management may delegate authority to approve
certain types of investment proposal. The top management may delegate authority by
limiting the amount of cash outlay, prescribing . the selection criteria and

holding the lower management levels accountable for results.

(iv) Project Execution: It is not possible to implement the project just by preparing a
capital expenditure budget and incorporating a particular proposal in the budget. A request
for authority to spend the amount should further be made to the Capital Expenditure
Committee which may like to review the profitability of the project if the circumstances
change. The funds for the purpose of the project execution must be spent only after
obtaining the approval the finance controller. Further, to have an effective control, it
is necessary to prepare monthly budget reports to show clearly the total amount allocated,
amount spent and the balance left. While implementing the project, it is better to assign
responsibility for completing the project within the given time frame and cost limit so as
to avoid unnecessary delays and cost over runs. Network techniques such as PERT and
CPM can also be applied to control and monitor the execution of the project.

(v) Performance Review: This is the last stage in the process of capital budgeting and
involves the evaluation of the performance of the project. The evaluation is made by
comparing the actual expenditure on the project with the budgeted, and also by
comparing the actual returns from the investments with the anticipated returns

The motives for an Investment;

What we observe, quite often, in the society is that a group of individuals carry out savings
while in other group carries out investment and the motives for savings may be unrelated

65
 with those for investments. Generally, private sectors inventions are carried out purely for
profit motives while public sectors ones may not necessarily aim at making profit.

The Basis for an investment Decision

We have agreed that the main motive for any investment decision is to make profit except for
the public sector investment. We judge the profitability of an investment decision by
comparing total revenue and total cost,

IF, T R >T C investment may take place

TR = TC the investor is indifferent

TR<TC investment may not take place.

However, revenues are in the future and the cost is in the present. Comparisons are only
possible if we convert the values into either present values or future values. This means that
there are several methods of investments .appraisals. Before looking at these methods let us
consider the elements to be analyzed before making an investment decision (determinants
of investment)

- Demand of the product

- Interest rate Possible competitor
- Location
- Price of inputs as well as price of the final. product

- Technology (methods of production)

- Time Factor.

The main principles and Information requirements for evaluating an investment proposal

a) Cash

investment in a project requires cash, so we need information on cash flow and

not accounting profit (TR -TC) to measure the benefit from a project. Accounting profits are
calculated after subtracting the cash and non. Cash expenses from the revenue of the period.

Depreciation is a non-cash expense. For example;

Supposed we buy a machine on the 1 st of January 20 l O the price of 1000000 francs. It

has a useful of five years (the process of at locating the cost of a fixed asset

66
 over its useful life is called depreciation). One simple method of calculating annual
depreciation is the Straight line method.

In the method, each year' s depreciation remains constant and can be calculated as

Follows;

¿
Annual Depreciation = cost of ¿ assets−salvage value number of years of useful life .

Note;

Cost of fixed assets should include

- Purchases price of asset

- Insurance paid
- Transportation and other cost incurred to move the asset to its current position.

Thus, from the above exercise

¿ assets−salvage value
Annual depreciation =
number of years

1000.000−0
=
5

= 200.000FCFA

2) Cash flow rather than accounting profit

Supposed we are told that profit before depreciation and tax (PBDT) amounts to
500,000 frs and the depreciation for the year is 300,000frs while the income tax rate is
50% . Calculate the profit after tax (PAT) and the cash flow for the year.

PBDT Less Dep Taxable Tax rate Accounts Add Dep Cash flow
Y(PBT) on profit (PAT+
PBT(50% (PAT) Dep)
)

500,000 300,000 200,000 100,000 100,000 300,000 400,000

PBDT= Profit Before Depreciation and Tax

Dep= Depreciation

ACCT = accounting Profit

67
 PAT = Profit after Tax

PBT = Profit Before Tax

Note we add depreciation expense to accounting profit because it is a non cash expense and the
cash is still within the enterprise.

2) long term principle

Gross working capital=inventories + receivable +cash(bank balances)

Net working capital= current asset-current liabilities

- Current are those assets that can be converted into cash within a period of 12months
- Current liabilities are those that can be liquidated or paid off within 12months

Long term fund principal means;

Investing in a project= investment in fixed assets +investment in networking capital.

Exercise

M and T enterprise acquired fixed asset with 20 million. Its current asset stands at 6
million while current liabilities are worth 4 million.

Require;

Calculate the Total Investment for M and T enterprise

Solution;

Total investment = investment in fixed asset + Net working capital bu

Net working = current asset -current liabilities

Fixed asset = 10 million

Current asset = 6 million

Current liabilities = 4 million

Total investment = 10,000,000+(6,000,000+4,000,000)

= 10,000,000+2,000,000

68
 = 12,000,000

Time value principle

Our evaluation of our investment proposal should take into consideration time
preference, e.g. investment proposals offering earlier returns are generally
more preferably than others. For example, a company is considering two investment
proposals x and Y and the following details are given concerning these proposals as
shown on the table below The figures are in dollars.

Items Proposal x Proposal X

Initial investment 100,000 100,000

Useful life 5yrs 5yrs

Scrp values Nil Nil

Dep method Straigt line method Straight line method

Income tax 50% 50%

PBDT for the two projects are given as follows

Years Yr I Yr 2 Yr 3 Yr 4 Yr 5

Proposal X 30,000 30,000 80,00 30,000 30,000

Propssal Y 80,000 30,000 30,000 30,000

Methods of evaluating an investment proposals or capital Budgeting Appraisal Technique

A business firm has a number of methods regarding various projects in which it can
invest fun.ls the capital budgeting appraisal methods of evaluation an investment
proposals will help a company to decide upon the desirability of an investment proposal
depending upon its relative income generating capacity. These methods provide the
company a set of norms on the basis of which, either it has to accept or reject the
investment proposal. The crucial factor that influences the capital budgeting decision is
the profitability of the prospective investment. There are many methods · of evaluating
profitability of capital investment proposals. The criteria for the appraising of
investment proposals are grouped into two types, viz;

1) Traditional Methods:
69
 (a) Accounting Rate of Return

(b) Pay back period method

2) Time-Adjusted method I Discounted cash 'Flow Method :

(a) Net Présent Value (NPV)

(b) Internal Rate of Return ( [R R)

( c) Profitability Index (Pl)

Method 1

The accounting rate method (ARR)

This method is also known as the Average Rate of Return method. lt measures the rate of
return by dividing the average annual profit from a project by the initial
investment or outlay cost. The following steps should be followed in computing the
accounting rate of return.

Note: all the data for the five methods will come from proposal X and proposal Y above.

Step 1

Calculate PAT for each of the projects

Project X

Yrs/details Yr 1 Yr2 Yr3 Yr4 Yr 5

PBDT 30,000 30,000 80,000 30,000 30,000

Les (dep) 20,000 20,000 20,000 20,000 20,000

PBT 10,000 10,000 10,000 10,000 10,000

Less income tax 5,000 5000 30,000 5000 5,000

50%

PAT 5,000 5000 30,000 5000 5000

N/B: PBDT; profit before depreciation and tax, PBT; profit before tax, PAT; profit after tax

Projet Y

Yrs/details Yr 1 Yr2 Yr3 Yr4 Yr 5

PBDT 80,000 30,000 80,000 30,000 30,000

70
Les (dep) 20,000 20,000 20,000 20,000 20,000

PBT 60,000 10,000 10,000 10,000 10,000

Less income tax 50% 5,000 5000 30,000 5000 5,000

PAT 5,000 5000 30,000 5000 5000

Step 2

We calculate the average annual PAT for each project. We do this by summing and dividing the
number of years.

Average Annual Profit =

∑ PAT
N ° of years

50,000
Project x= =$ 10,000
5

Project Y=
∑ PAT =
50 ,000
=$ 10 , 000
N ° of years 5

Step 3

We calculate the ARR using the formular

Av . annual profit 100

ARR= x
initial investment 1

10,000 100
Project x= x =10 %
100,000 1

10,000 100
Project Y= x =10 %
100,000 1

Base on the example above, the investor is different because both projects have the same
ARR(10%)

Decision rule (A_ppraising)

Given projects, a n d using the ARR method, the investor should choose the project

with the highest ARR.

NB: We can also calculate the ARR using the earnings per unit of investment. With

this method of ARR, the total profit after tax is divided by the total investment.

71
 total PAT 100
Earning per unit of investment= ×
Net Investment 1

Decision Rule

Advantage of ARR

i) The main advantage is that, it is simple, easy to calculate and be understood.

ii) Information is readily available from the profit and loss A/C

iii) Unlike the pay-back period method, this method takes into consideration the entire
earnings of a project in calculating the rate of return. Hence, it gives a better view of
profitability.

iv) This approach gives due weight to the profitability of the project.

v) where a number of capital investment proposal are being considered, a quit decision can be
taken by ranking the investment proposals according to their ARR’s

vi) this method is based upon accounting concept of profits, and therefore can be readily
calculated from the financial data.

Disadvantages of ARR

i) It does not consider the time value of money

ii) It ignores the cash flows which are more important than the accounting profits.

iii) This method uses the straight line method of depreciation. Therefore, the method will not be
easy to use, and will not work practically, once a change in the method of depreciation takes
place.

iv) This method ignores the distinction in the size of investment required for individual
projects. Competing investment proposals with the same accounting rate of return may require
different amounts of investment.

v) It is biased against short-term projects ..

72
 Method 2

The Pay back Period

This is the most popular and widely recognized traditional method of evaluating the
investment proposals. It is based on the principle that every capital expenditure pays
itself back within a certain period, out of the additional earning generated from the
capital assets. The pay-back period may be defined as "as the number of years required
to recover the original cash outlay invested in a project". It can be calculated with the

Formula;

cash outlay
Pay back period=
annual cash flow

NB: it is the time period for returns of the initial investment. Unlike there ARR, the pay back
period is a cash flow method. The following steps are required in computing the payback period.

Step 1.

From the given information, we calculate the cash flow for each year by adding

PAT and DEP. We are going to consider proposai X and Y from the example given in

the ARR method above.

Projet X

Years Yr 1 Yr2 Yr3 Yr4 Yr 5

item

PAT 5,000 5000 30,000 5000 5000

add (dep) 20,000 20,000 20,000 20,000 20,000

Cash flow 25.000 25.000 50.000 25.000 25.000

Step 2

Sum up the cash flow from Y1 up to the point where we cover our initial investments.

Cash flow of Y1+Y2+Y3= Initial investment=100.000FCFA

Therefore for the payback period of project X=3 yrs

73
 Project Y

Years Yr 1 Yr2 Yr3 Yr4 Yr 5

item

PAT 5,000 5000 30,000 5000 5000

add (dep) 20,000 20,000 20,000 20,000 20,000

Cash flow 25.000 25.000 50.000 25.000 25.000

Sum of cash flow= Y1+Y2+Y3= initial investment= 100,000FCFA

Thus the payback period of Y=3yrs

Decision Rule (Appralsing)

The shorter the Payback Period, the better the investment proposal]. Concerning investment X
and Y above, the investor is indifferent because the two projects have the same pay back
period.

Advantages of payback period

i) It is a cash flow method

ii) It is fairly simple to calculate and easy to understand
iii) It indicates the riskiness of the project.
iv) The main advantage of this method is that it is simple to understand and easy to
calculate
v) lt does not involve any cost for the computation and requires lesser time and labour as
compared to other methods of capital budgeting.
vi) This method is most suitable when the future is uncertain. The shorter the pay back
period, the less risky is the project. Therefore, it can be considered an indicator of
risk.
vii) It may be a suitable technique where risk of obsolescence is high. in such cases,
projects with shorter pay back period may be preferred as the changes in technology may
make other projects obsolete before the costs are recovered.
viii) Due to its short-term approach, this method is particularly suitable to a firm
which has shortage of · cash or whose liquidity position is not particularly
good.

74
 Disadvantages

i) it does not consider the other cash flow after the [payback period i.e. it does not: take
into account the full life of the investment proposals

ii) It ignores the rime value of money and does not consider the magnitude and timing
of cash inflows, it treats ail cash flows equally though they occur in different periods,
The fact that cash received today is more important than the same amount of cash
received after some period is ignored by this method,

iii) lt does not take into take into account the cost of capital .which is a very important
factor in making sound investment decisions. ·

iv) It ignore:;; the cash generation beyond the payback period, and t\,is can he seen

more when measuring the liquidity or profitability.

v) ' lt does not take into account the interest factor involved in an investment
outlay.

Consolidation exercise

A company is considering two capital investment proposals. The two proposals are for the
manufacture of the same products. They are expected to operate for 4 years. The initial capital
investment is 40 million. Only one proposal can be accepted. Their expected Profit before
depreciation and tax are given as follows;

Years Project A Project B

1 10,000,000 20,000,000

2 10,000,000 20,000,000

3 25,000,000 20,000,000

4 25,000,000 5,000,000

Depreciation is to be charged on a straight line basis and the company tax rate is 40%

Required;

Evaluate these proposals

a) The accounting rate of return

75
b) the pay back period
Solution;
¿ cost−straght values
Depreciation=
N ° of yrs
40,000,000−0
= =10,000,000
4
Project A

Yrs/details Yr 1 Yr2 Yr3 Yr4

PBDT 10,000,000 10,000,000 25,000,000 25,000,000

(dep) 10,000,000 10,000,000 10,000,000 10,000,000

PBT 0 0 15,000,000 15,000,000

Income tax 0 0 6,000,000 6,000,000

PAT 0 0 9,000,000 9,000,000

Av. Annual profit =

∑ PAT =
18,000,000
=4,500,000
n °of yrs 4

Av . Annual Profit 100

Therefore ARR= ×
initial investment 1

4,500,000 100
= × =11.25%
40,000,000 1

Projet B

Yrs/details Yr 1 Yr2 Yr3 Yr4 Yr 5

PBDT 20,000,000 20,000,000 20,000,000 20,000,000 5,000,000

(dep) 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000

PBT 10,000,000 10,000,000 10,000,000 10,000,000 (-5.000.000)

Less income 4,000,000 4,000,000 4,000,000 4,000,000 0

tax 50%

PAT 6,000,000 6,000,000 6,000,000 6,000,000 (-5.000.000)

Dep 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000

Cash flow 16.000.000 16.000.000

76
 Av. Annual Profit =
∑ PAT =
13,000,000
=3.300 .000 F
n °of yrs 4

Av . Annual Profit 100

= x
initial investment 1

3,300,000
= X 100=8.125 %
40,000,000

Projet A

Years Yr 1 Yr2 Yr3 Yr4

ite
m

PAT / / 9.000.000 9.000.000

Dep 10,000,000 10,000,000 10,000,000 10,000,000

Cash flow 10,000,000 10,000,000 19,000,000 19.000.000

The pay back period = ∑ Yr 1+ ∑ Yr 2+∑ Yr 3

ARR = 10,000,000+ 10,000,000,000+19,000,000+19,000,000

= 58.000,000

But initial investment = 40,000,000

Required amount = 1.000.000

1,000,000
= therefore ×12=.63
19,000,000

Pay back=3yrs, 19days

Project B

The payback period = 16.000.000+16.000.000+16.000.000

= 48.000.000

But initial investment = 40.000.000

Required amount = 8.000.000

800.000
Therefore = ×12 6 months
16.000.000

77
Payback= 2 yrs, 6 Months

78
Decision (appraising)

a) With respect to ARR investment A should be chosen. This is because ARR of project

Ais l l.25% which is higher than 8.125% for project B.

b) Concerning the payback period, method, project B should be chosen because it has a shorter
payback period of 2 Yrs 6 months compared to 3 Yrs 19 days of project A.

The Time Value of Money

The main objective of a business enterprise is to maximise the share holders' wealth. This
wealth is measured considering the rime value of the cash inflows expected. A sum of money to
be obtained in the future has a lower present value compared to the same sum paid now. The
reason is that the current amount can be invested to earn a return or interest. The interest is the
return . earned by the amount paid to the owner for sacrificing current consumption. The
principal ·is· the amount of money borrowed to the

investor, The lime is the period during which the borrow can use the principal, Th

interest rate or discount: rate is the percentage of the principal paid by the borrower to the lender
for using funds which are no his Financial institutions can measure this interest rate in two
ways; simple and compound interest.

Simple interest

With this method of calculating interest, interest is paid only on the principal amount.

Mathematically written as Simple interest = PV x I x t/100 OR 1200 OR 36000

Where PV = the present value or principal

I= interest rate or discount rate

t= time or period

Application exercise

An investor borrows 100,000 FRS at 15% per annum for 6 months. What will be the simple
interest by the borrower?.

SI = PV x i x t
79
Pv = 100,000

i = 15%

t = 6months

100,000× 15 ×
SI= =7,500 frs
100 ×12

Compound interest

In this method, interest is calculated on the accumulated capital grown over a

number of years on the Individual savings, i.e interest · is calculated on principal +
interest. .

See present values for details

The future of present sum

in determining the future value of a present sum, we measure the value of an amount that is
allowed to grow at a given rate over a time period. for· example; if an investor or a lender
borrows 100m FCFA are an annual rate of 10% then he expects 110m FCFA at the end .of
the year hence the formula. for calculating the future value of a present sum is given as

where FV=Future value

PV = Present value

I = annual rate of interest

Hence, 110m=100m(1+0.1)

When the amounts of money are borrowed for periods greater than 1 year, there is the
compounding of interest

Hence the general formula for the future value is

FV= PV(1+i)n

Where n is number of years or periods

Application exercise

Let us suppose that the 100.000.000 at 10% interest was borrowed for 4 years, what will be its
future value
80
FV = 100.000.000 (1+0.1)4

= 146.410.000

The present value of a future sum (Discounting)

The present value is the exact opposite of the future value, for example we earlier

determined the future value of 100,000,000 FRS for 4 years at 10% and had 146,410,000

FRS, we could reverse the process to state that 146,410,000 F received 4 years into the future

With a discount rate of 10% is worth 100,000,000 FRS today. The formula for calculating

the present value is derived from the original formula for future value

Fv
PV=
¿¿

Note; with the present value of a future sum, the interest rate is called the discount rate.

Application exercise

What is the present value of 300M frs which is due in a year’s time at a discount rate of 10%

Fv
PV =
¿¿
300
Pv
¿¿

= 272.73Mfrs

this means that an investor is indifferent between 272. 73 Mfrs now or 300 Mfrs in a year
rime at discount rate of 10%

Exercise 2

Assume a discount rate of J 0%, what will be the present value of 300.000JJOOF to

be received. al the end of each year for 5 years.

Fv
PV=
¿¿

300 M
PV=
¿¿

PV= 273.73+247.93+225.39+204.9+186.28
81
 ∑ PV =1137.26 Mfrs
Alternatively

We can also calculate present values with the use of financial tables, notably, the present interest
table where the PVIF is referred from the financial table

II) Calculate the PV of 1.000.000F after 20 years at 15%

PVIF 2

Years, 15%=0.6611

PV= amount X PVIF

= 1.00.000 X 0.611

61,100

III) Find the PV of 1000 dollars assuming a 10% per year time value of money

a) receives one year from now

b) received at the end of the 5th year
c) received at the end of the beginning of the 6th year

Solution

a) PVIF 1 year, 10%=.9091

PV = Amount X PVIF

=$1000 X .9091

b) PV=$1000 X 0.6209 = $620.9

c) PV=$1000 X 0.6209 = $620.9

NB: An important assumption of the present value is that all sum of money are received or paid at
the end of the year.

Annuities

Definition: Annuities are a series of equally spaced equal amounts.

Application

82
Assume you will receive an annual scholarship of 100.000 dollar at the end of each year for the
next five year. If r is 12%, what is the PV of this annuity?

Solution

PV = Amount x PVIFA

= 100,00 x 3.6048 from annuity table

= $360.480

This amount can be explained as follows

Year Amount Pv

1 100,000x0.8929 89,290

2 100,000 x 0.7972 79,720

3 100,000 x 0.7118 71,180

4 100,000 x 0.6355 63,550

5 100,000 x0.5674 56,740

Note: The PVIF are obtained from the financial table

Application

A company borrows $94, 770 from a bank at an annual interest rate of l 00%. The loan
plus interest is to be paid back in five equal instalments at the end of each year of the following
five· years. Find out the annual instalment.

Solution

Px = 94,770

r = 100%

n = 5 years

pvIFA = 3.7908(from table)

PV
annual payment =
PVIF

94,770
= =$ 25,000
3.7908

What is the PV of 25.000 dollars paid annually for five years if r=10%

83
 Solution

Pv = amount x PVIFA

= $25.000 x 3.7908 = $94770

Exercise

A company borrows 10.000 dollars at an annual interest rate of 15% and must pay back the
loan including interest in two instalments. Find the annual instalment

Solution

Pv = 10.000, r = 15% n= 2yrs

PvIFA = 1.6257

PV 10,000
Annual payment= = =$ 6151.19
PVIF 1.6257

= 6151.2

Year Beginning Interest 15% Total due Annual Ending

amount repayment balance of
loan

1 10,000 15,00 11500 6151.2 534.8

2 5348.8 802.32 6152.2 6151.2 Nil

Exercise II

Do the above example given that the loan amount was 13005.60

Pv=13005.60, r=15% n= 2yrs

PVIF = 1.6257

PV 13,006.60
Annual payment = = =8,000
PVIF 1.6257

Year Beginning Interest 15% Total due Annual Ending

amount repayment balance of
loan

1 10,000 15,00 11500 6151.2 534.8

2 5348.8 802.32 6152.2 6151.2 Nil

84
Method 3

The net present value of investment appraisal

This is the modem method of evaluating investment proposals and takes into
consideration the time value of money. We know, the objective of the firm is to
create wealth with existing and future resources to produce goods and service. To
create wealth, the cash inflows must exceed the present value of all anticipated
cash

Outflows. The net prescript values of all inflows and outflows o f cash occurring during
the entire life of the project is determined separately for each year by discounting these
flows by the firms cost of capital or at a predetermined rate. The method discounts the net
cash flows from the investment by the minimum required rate of return and deducts
the initial investment to give the yield from the fonds invested. it is a discounted cash
method flow which means that it takes into account the time value of money.

Decision Rule (Appraisal)

If the yield is positive or zero, i.e., when present value of cash inflows exceeds or is equal
to the present value of cash outflows, the project is acceptable. If it is negative the
project is not acceptable. If there are two mutually exclusive projects to be selected the
projects should be ranked in order of net present value i.e., the first preference
should be given to the project having maximum positive net present value.

85
Steps

l) Calculate the Pv of all future cash flows

2) Calculate;

NPV = Pv of future cash flow -i nitial investment

Investment X

Years 1 2 3 4 5

Cash flow 25.000 25.000 25.000 25.000 25.000

PV at 10% 45.455 20660 18782.5 17.75 15522.5

Total Pv of future cash flow= 117495

100,000
Less Initial Investment =
17,495

Decision 1 appraisal

Investment Y is better than investment X because it has a Higher NPV of $17495

compared to $13.550 for investment X.

Advantages of the NPV method

i) It is a cash flow method ( discounted)

ii) It takes into consideration the time va1ue of money

iii) Unlike the Payback period method, it takes account of cash flow during the
entire life of the investment project.

iv) NPv is considered the most scientific method .of investment appraisal

v) 1t is based on the entire cash flows generated during the useful life of the
asset and the true profitability or the investment proposal can be evaluated.

vi) lt is consistent with the objective of wealth maximisation of the owners.

86
 vii) It is based on the assumption that cash flows determine the wealth
of shareholders,

Disadvantages of NPV

i) Does not answer the question of "how much rate of return does the project provide".

ii) It is difficult to understand and compute ..

iii) The net present value is calculated by using the cost of capital as
a

discount rate.

iv) Calculation of cost of capital is itself complicated .. Moreover, desired rates of

return vary from year to year. .

v) It is an absolute measure and does not give solutions when two projects
are

being considered involving different amounts of investment.

vi) It may not give satisfactory results where two projects having
different effective lives are compared,

Method 4

Internal Rate of Return of Method of investment Appraisal (IRR)

This method is popularly known as time adjusted rate of return method or

discounted rate of return method. The internal rate of return is defined as the
rate of return which equates the present value of anticipated net cash flows with the
initial outflow. The Internal Rate of Return is .also defined as the rate at which present
value is zero. The internal rate of return is found by trial and error method.

As we have seen, the NPV gives results in absolute figures when cash flows are
discounted at a discount factor. This u n d o u b t e d l y is confusing · to some s t u d e n t s .
To minimize this confusion, they look for an ARR which takes into account the time
value of money. Such a rate is called the Internal Rate of Return (IRR)

IRR is also called the trial and error method because we discount cash flow at a

Rate and keep adjusting ‘r’ until NPV = 0.

87
88
How to calculate lRR

IRR is also called the trial and error method because we discount cash flow at a rate
and keep adjusting r until NPV = 0. However, calculations are easier when the
projects give some cash inflows each year (Annuities)

Application Exercise I

A new equipment will cost $16.900 and will give a cash flow of $3.000 per year for
12 years. Use l RR to appraise this proposal.

Solution

Initial investment = $16. 900

Cash flow per year = $3.0

Number of years, n = 12

Step 1;

16,900
Divide the initial investment by the annual cash inflows = =5.63
3,000

Step 2;

Use PV on annuities where n=12 and find out ‘r’ that gives PVIFA nearest to 5063. From the
table the value nearest to 5.63 is 4% or between 14% or between 14% and 15%.

Decision Rule ;

Accept the project of IRR is greater than the cost of capital (r) Reject the project of IRR is
less than (r). The investor is indifferent if IRR = r

Application Exercise II

A machine cost $11070; Annual c a s h inflow is $2.000 for 8 years. The company has a cost
of capital (r) of 13%. Calculate I R R and decide whether the project should be accepted
or rejected.

Solution

11, 070
=5.535
2,000

From the table, the value nearest to 5.535 is 9%

Decision Rule Apraisals

89
 If the internal rate of return exceeds the required rate of return, the project is
acceptable. Conversely, if the projects internal rate of return is lower than the
required internal rate of return, it is not acceptable. The internal rate of return
technique is significantly used in case of ranking the proposal. The projects with
the highest rate of return will be ranked first compared to the lowest rate of return.

From the example above, the project should be rejected since IRR (9%) is less
then the cost of capital (r) 13%.

Application exercise III

A machine has a useful lifespan of 1 year to generate 900.000.000f at the end of its
useful year. The machine cost 800.000.000f today and has no scrap value at the end
period. The cost of capital is 10%. Use IRRR method to access the profitability of this
proposal.

FV
PV=
(1+r )

900
800=
(1+r )

800(2+r) =900

800+800r=900

800r=100

100
R=
800

R= 0.125

R= 12.5%

Decision

This proposal is profitable since IRR(12,5%) is greater than the cost of capital€ 10%.

Advantages of IRR

I. It is a cash flow method.

II. it considers the tune value of money.

90
 III. Unlike the payback period method, IRR considers cash inflows over the whole life of
the project,
IV. IRR gives an overall discounted rate of return.
V. It considers the profitability of the project for it entire economic life and hence enables
evaluation of true true profitability
VI. It considers the time value of money
VII. It takes into account the total cash inflows and each outflow.
VIII. it provides for uniform ranking of various proposals due to the percentage rate of return.
IX. It is in conforming to the firms objective of maximization of profitability and is considered
to be a more reliable technique of capital budgeting.

Disadvantages of IRR

i) It is relatively difficult to calculate

ii) Sometimes we may have multiple IRR’s

iii) it is difficult to understand and evaluate

iv) It involves very complicated computational work based on trial and error method.

v) It produces multiple rates and may not give unique answer in all situations.

vi) The results of internal rate of return method may differ when the projects
under evaluation differ in their size, life and timings of cash flows.

Method 5

Profitability index methods (PI)

It is also time-adjusted method of evaluating the investment proposals and is sometimes called
the Benefits-cost ratio. The profitability index is the present value of anticipated net future cash
flows divided by the initial outlay.

PV of all future cashflow

It is measured as PI =
initial investment ( outlay)

Division rule

Accept project, if PI >1

Or reject, if PI < 1

Application exercise

Let us calculate the profitability index (PI) of proposals X an Y from the NPV method above.
91
 discounted future cas h flow 113550
PI x= = =1.136
initial investment 100,000

discounted future cas h flow 117495

PI y= = =1.175
initial investment 100,000

Decision

The 2 proposal are profitable because their PIs are greater than 1 but proposal Y with a PI of 1.75
is preferred to proposal X with a PI of 1.136.

Advantages

- It is a cash flow method.

- It takes into account all cash flows I the entire life of the project.
- It takes into account the time value of money
- It involves less computational work than internal rate of return method.
- Selection of the projects on the basis of the value of index is easier.
- Useful in ranking of projects on the basis of the value of index.
- It takes into account the entire stream of cash flow generated during the useful life of the
asset.

Disadvantages

- It is difficult to understand
- It is very difficult to understand the analytical part of the decision on the basis of
profitability.

Final choice of evaluation Method

The choice of t h e evaluation technique depends upon the objective of the

management in the investment decisions .. However, those projects which will be
in the interest of shareholders and can earn more rate of return than other
alternative investment opportunities should be preferred ..

Revision Question

An investor is considering two capital investment proposals. Both proposal are for similar
products and are expected to operate for four years. Both require an initial cash investment
of 4.00.000frs in machinery and 50,000 frs in working capital. Working capital

92
investment will be recovered at the end of the 4th year. Only one project can be accepted. The
expected profits before depreciation and taxes are as follows:

Project A Project B

Year 1 120,000 200,000

Year 2 120,000 200,000

Year 3 230,000 200,000

Year 4 230,000 100,000

Depreciation is to be charged on the straight-line basis. The company’s income tax rate is 40%
and its cost of capital at 10 % per annum. Discount factor at 15%. Year 1 0.8696 year 2
0.7561 year 3, 0.6575 year 4, 0.5718

Required

Calculate for both projects

Average rate return

The payback period

Which if any should be accepted? Use the ARR method for the appraisal

TUTORIAL EXERCISES ON INVESTMENT APPRAISAL

1) The management of XYZ Enterprise decides to purchase equipment worth 50 000 000
CFAF whose probable useful life is 5 years with a salvage value of 10 000 000 CFAF. The
turnover of the manufactured products will consequently increase by 32 000 000 CFAF
annually. The additional manufacturing expenses will amount to 14 500 000 CFAF per annum
with the income tax being 33%, cost of capital being 8% and deprecation to be on a straight
line basis.
Task
Appraise the investment using the NPV and PI methods.

2) The Cameroon Bottling Company Ltd is considering the purchase of a new machine that is
to cost 4 500 000 CFAF and the annual revenues to be generated net of expenses have been
projected at 1 500 000F, 2 000 000F, 2 500 000F, 1 000 000F and 500 000F respectively over
the next 5 years.
Tasks:
93
If the cost of capital is 10%, appraise the investment using the NPV and PI methods.

3) A PLC has to choose which of three mutually exclusive projects to undertake at a cost of
capital is 14%. The cash flows of each project would be as follows:
Year Project A (CFAF) Project B (CFAF Project C (CFAF
0 (12 000 000) (12 000 000) (12 000 000)
1 4 000 000 6 000 000 3 000 000
2 4 000 000 5 000 000 3 000 000
3 6 000 000 5 000 000 3 000 000
4 6 000 000 4 000 000 3 000 000
5 1 500 000 (1 000 000) 3 000 000
6 - - 3 000 000

Required:
a) Which of the project should be undertaken using the NPV method?
b) Which of the project should be undertaken using the PI method?
c) What is the expected return on each of the projects?

4) Suppose we are deciding whether or not to open a store in a new shopping market. The
require investment in improvement is 500 000F. The store will have a 5 years life span. The
require investment will be depreciated over 5 years (straight line). The tax rate is 25%. The
revenues and operating expenses of this project over 5 years are shown below:
Elements Year 1 Year 2 Year 3 Year 4 Year 5
Revenues 433,000 450,000 266,667 200,000 133,333
Expenses 200,000 150,000 100,000 100,000 100,000
Required: Calculate the accounting rate of return.

5) A proposed investment has an initial cost of 5 000 000 CFAF with a scrap value of 1 000
000 CFAF. The projected income before depreciation and taxes are 1 000 000F, 1 200 000F, 1
400 000F, 1 600 000F and 2 000 000F over the five years period respectively. The tax rate is
30% and depreciation is straight line. Projects under this category are expected to return 15%.
Required: Project appraisal using the ARR.

94
6) A business undertakes a high risk investment project and requires a minimum expected
rate of return of 17% p.a on the investment. A proposed capital investment has the following
expected cash flows (000 CFAF):
Year 0 1 2 3 4
Cash Flows (FCFA) (50,000) 18,000 25,000 20,000 10,000
a) Calculate the NPV of the project if the cost of capital is 15%
b) Calculate the NPV of the project if the cost of capital is 20%
c) Use the NPVs to calculate the IRR of the project
d) Recommend on financial grounds alone whether this project should be accepted

95
 7) A project costs 16 000 000 CFAF and is expected to generate cash inflows of 8 000 000, 7
000 000 and 6 000 000F at the end of each year for the next 3 years. Assuming that IRR is the
rate at which the project will have a zero NPV, determine the IRR using the trial and error
method.

8) A company is considering two projects A and B, each lasting two years. A requires an
initial investment of 100 000F at the beginning of Year 1. If, and only if, A returns a positive
net present value, B will start at the beginning of Year 3 with an initial investment of 120
000F. The estimated cash flows from the two projects at the ends of Years 1 to 4 with their
probabilities are given as follows.
Project A (000s) Project B (000s)

Year 1 CF 45 125 Year 3 CF 70 80

P 0.25 0.75 P 0.5 0.5
Year 2 CF 55 70 Year 4 CF 60 90
P 0.4 0.6 P 0.7 0.3
For both projects, the cost of capital is 11%.
Required:
i) Determine the expected net present value of project
A. ii) What is the probability that project B will go
ahead? iii) If project B should go ahead, what will be its
expected net present value?
iv) In the light of the estimates, should project B be abandoned?

9) YEGHA Company Ltd uses the Net Present Value and Internal Rate of Return methods to
appraise its investment opportunities. This business has two investment opportunities. The
management has contacted you as a finance expert to advise her on which project to engage in
since they have limited funds. Both of the projects have a live of three years and an initial
investment outlay of 18 000 000 CFAF with the cost of capital being 8%.

INVESTMENT OPPORTUNITY 1:
The projected net cash flow summarised statements for this project are as follows:
 There is a probability of 70% for the cash flow of the first year to be 8 000 000
CFAF or it may turn out to be 10 000 000 CFAF.

96
  There is a probability of 75% for the cash flow of the second year to be 10 000 000
CFAF or it may turn out to be 12 000 000 CFAF.
 There is a probability of 40% for the cash flow of the third year to be 12 000 000
CFAF or it may turn out to be 6 000 000 CFAF.
INVESTMENT OPPORTUNITY 2:
This is a traditional contract whose cash flow has always respected the following constant pattern:
 Annual revenue (excl. VAT): 9 000 000 CFAF.
 Annual expenses (including straight line depreciation): 7 800 000 CFAF.  The
income tax rate on this contract is 10%.
Required:
a) Determine the expected present value of project A using a probability tree diagramme.
b) Determine the expected profitability of project B.
c) Indicate your choice of investment, based on expected profitability.
d) Determine the IRR of project B using the trial and error method.
iii)

CHAPTER EIGHT: COST OF CAPITAL

Investors expect a return for investing their funds in the shares or debentures of a customer. The
return should be according to the degree of risk taken. This means that debt holders should be
somehow satisfied with lower returns than shareholders. Returns from the investors point of view
is the cost of capital to the company's point of view.

We have used the symbol(r) to express the expected rate of return, but we will now use
different symbols for clear understanding.

Kp = expected ‘r’’ for preference share capital

Kd = expected "r" for debt capital

Ke = expected "r" for equity capital.

97
To keep the discussion slightly simpler, we assume that the company has issued permanent
shares and debentures. Before tax and after tax cost of capital in the case of debt capital. Interest
paid is considered a business expense and reduces the company’s income tax liability.

Dividends are net business expenses and do not offer tax advantages. They are only considered
after net profit

Cost of Preference Capital( Kp)

Dividend at a fixed rate is given on preference capital.

Dp
Kp
p0

Kp=cost of preference share capital

Dp= Dividend preference share

P0= arrested market price per preference share

The company management is more concerned with estimating the marginal or future cost of
capital than the historical or past cost of capital. Therefore, we should always calculate cost of
capital using the market value or prices rather than the par value or nominal value.

Application exercise

A company gives preference dividend of 16% per annum and the par value of its preference share
is 100$ each. What will be the estimated cost of Preference share capital if the preference shares
are currently being traded at 120$ each.

Solution ;

Dp
Kp
p0

16 100
Dp= × =16
100 1

= 16/120=0.133 or 13.3%

If we were given Dp and Kp, we could estimate the current market price (P0)

16
0.133=
p0

p0 ( 0.133 )=16

98
 0.133 p 0 16
=
0.133 0.133

p0=120

Exercise II

A company pays a dividend of 20 dollars per annum. If your expected return is 10% per annum,
what will you pay for the share?

Solution

Dp
Kp
p0

20
0.0=
p0

0.1 p0=20

0.1 p 0 20
=
0.1 0.1

p0=200

Cost of debt capital Kd

A fixed rate of interest is paid per annum on dept. we assume permanent debt

1
Kd (before tax) =
p0

Kd = Cost of debt

I= interest amount paid per annum per debenture

p0= Current market price par debenture

1
Kd (after tax)= (1−t)
p0

t= income tax rate applicable to the company.

Application exercise

A company pays 15% per annum on its debts. The company’s income tax rate is 40%.
Calculate the before tax and after tax cost of debt.

Solution

99
Because the market value is not given, a reasonable assumption is to take the market
value to be equal to the par value. Again, because we are told of a 15% interest, then the par
value is I OO, since we are talking of percentage, the par value = market value=100

1 15
Kd(before tax)= = ×100=15 %
p 0 100

I ( 1−t ) 15−1−0.4
Kd(after tax) = = =15 ×0.6=0.09∨9 %
p0 100

Cost equity capital

A company issues ordinary shares capital and in return gives dividend per year. The
dividends are paid on par value of shares and may normally be expressed as

Dividend per shares (D P S).

Relationship between dividend per shares and dividend as a per percentage

A company has a par value of $0.5 per ordinary share. lt pays 25% dividend per share
(D.P.S). what is the dividend per share (DPS)?

25
DPS = × 0.5=¿ $0.125 or 12.5 cents
100

With 1000 shares you will get (0.125 x l 000) = $125 as total dividend. The par value of
1000 shares = 1000x0.5=$500. Thus if he gets a dividend of $12 5 then he makes a dividend
which is equal 25% ( 12.5/500 x 100/1).

Suppose the market value of the same share is $2 each. If the .company pays 25% dividend, will
the dividend paid by the company change? The answer is no, because dividend is calculated
based on par-value and not market price.

D.P.. S can be assumed to remain constant year after year or it can be assumed to grow
year after year (over time). We will examine the cost of capital under these two assumptions.

a) When D.P.S remain constant each year

Dp
Ke
p0

Ke = cost of equity capital

100
 D = D.P.S assumed to remain constant per year

p0= market value per share of ordinary capital, Ex-dividend

Application exercise 1

A company gives a D.P.S of $2 each year. The par value of the share is $10 and the
market value of the share is $20 per share. The dividends are expected to remain constant
in the future. Calculate Ke ( cost of equity capital).

Solution

D 2
Ke= = =0.1 ot 10 %
p0 20

a) When DPS grows at a constant rate (fixed rate per year)

D1
Ke = +g
p0
Where D1=DPS at the end of one year from now
g= the constant compound growth rate in DPS per year
Application 1

A company experts to pay a DPS of $3 next year ,the market price of the share at present is
$50 per share. The DPS is expected to grow in the future at a constant rate of

7% per annum. Calculate Ke

Solution
D1 3
Ke = Ke = + g= +0.07=0.13∨13 %
p0 50
Question II

A company has just paid a dividend of $5 per share, The D.P.S is expected to

grow in future at a constant rate or J 0%) per year and the current market value of the
share is $55 per share, estimate the cost of equity capital (Ke)

D0 (1+ g)
Ke = +g
p0
D0= current D.P.S
5 (1+ 0.1 )
Ke= +0.1=0.2∨20 %
55
Exercise III

101
A company’s share has a par value of $10 each but a market value of $8 per. share.

The company has just paid a DPS of $ l each and the D.P.S is expected to grow in the
future al a constant rate of 6%. Calculate Ke.

Solution

D0 (1+ g)
Ke = +g
p0

1 ( 1+0.06 )
Ke = +0.06=0.1925∨19.25 %
8

NOTE: shares are traded at either EX-dividend prices or cum-dividend prices. Ex-dividend
means excluding the dividend. In an ex-dividend deal, the seller retains the right to dividend just
declared by the company. Cum-dividend means including dividends benefits to the buyer.

EX-dividend price= Com dividend price – current D.P.S

Application

The cum-dividend price of a share is $25 per share. The company has just declared a D.P.S of
$2.5 per share and the dividends are expected to grow in the future at a constant rate of 8%.
Calculate the cost of equity capital (ke)

Solution

Ex-dividend= cum dividend-D.P.S

= $25-$2.5

= $22.5

D0 (1+ g)
Ke = +g
p0

2.5(1+0.08)
Ke = + 0.08=.2∨20 %
22.5

Calculation of market price per equity shares

p D1
0=¿ ¿
r −g

When D.P.S grows at a constant rate per annum. The assumption is that r or Ke must be greater
than g

102
Weighted Average Cost of Capital W.A.C.C

W.A.C.C is the overall cost of raising capital from a mix of sources such as equity, preferences
and debt.

The uses of W.A.C.C

W.A.C..C is a very useful concept for every financial manager

1) W.A.C.C is the overall cost of capital

2) W.A.C.C is used as the minimum required rate of return or the discount rate used to evaluate
an investment proposal or project.

Consider the W.A.C.C table below

Sourced Amount Proportions After tax cost W.A.C.C

Debt 5m 0.5 10% 5.0%

Preference 3m 0.3 15% 4.5%

Equity 2m 0.2 20% 4.0%

Total 10m 1 W.A.C.C 13.5%

13.5
10 M =1,350 , 00
100

This amount is partitioned to share holders and debt holders as follows

Debt = 5m x 10%=500.000 will go to debt holders

Pref = 3m x 15% = 450. 000 will go to preference share holders

Equity= 2m x 20%= 400.000 will go to equity share holders

Total = 1.350.000

Problem

The company has issued 10.000 equity shares of $10 each, and the market value

of each equity share is $12. The company is expected to pay a dividend of $1.5 per share
next year. The dividend per share is expected to continuously grow in the future al the.

103
 compound rate of 6% per annum. The company has also issued 1000 preference shares of $1
OO each, the market value of which is $90 per preference share. The company pays
preference dividend of 10% per annum. The company has also issued 200 debentures of

Revision Exercise

A company has issued bonds of $5.000.000 at an interest rate of 18% per annum, Its
preference shares amount to $200.000 and the company pays 16% preference dividend.
The company has also issued $100 shares for a total amounting to $3.000.000. Next year' s
dividend per share on equity capital is expected to be $25 per share and the D.P.S is
expected to grow continuously in the future at a compound rate of 4% per annum, The
company's tax is 30%.

Required

a) Calculate Ke
b) Calculate Kd
c) Calculate Kp
d) Calculate W.A.C.C

CHAPTER NINE: CAPITAL STRUCTURE DECISIONS (EBIT & EPS) ANALYSIS

One widely used means of examining the effect of leverage is to analyse the relationship
between earnings before interest and tax (EBIT) and earnings per share (EPS).

104
Essentially, the methods involve the comparison of alternative methods of financing under
various assumptions as to EBIT.

Application

A company has 100.000 equity shares of $10 each. It needs additional tl.000.000 to finance
expansion. It has .3 options;

Issue additional equity shares of $10 each

2 Raise loans at 12% per annum

3 Raise preference share capital at 11 % per annum. The company’s EBIT is expected
to be $800.000 and it is within U1e 40% tax bracket. Which .financing option will maximize
E.P.S.

Solution

Figures 000’s

Equity DEBT Preference

EBIT 800 800 800

Less interest / 120 /

EBT 800 680 800

Less 40%(tax) 320 272 320

EAT 480 408 480

Les pref. Dividend / / 110

Earnings for equity 480 400 370

N0 of Equity share 200 100 100

EPS 2.4 4.08 3.7

Or

105
 Figures 000’s

Equity DEBT Preference

EBIT 800 800 800

Less interest / 120 /

EBT 800 680 800

Less 40%(tax) 320 272 320

EAT 480 408 480

Les pref. Dividend / / 110

Earnings for equity 480 400 370

N0 of Equity share 200 100 100

EPS 2.4 4.08 3.7

Where EBIT= earnings before interest and tax

EBT = Earnings before Tax

EAT = Earnings pee equity share. Interestingly, EPS under the debt option is higher than the
preferences dividend. This is due to tax shield on the interest option.

Decision

Going by analysis above, the company should go for the debt option to maximize its

earnings per. equity share. Interestingly, EPS under the debt option is higher than the
preference option even though 12% interest rate was higher than 11 o/o preference dividend.
This is due to the tax shield on the interest option.

Example 2:

A company has 200.000 ordinary shares. It now needs $4.000.000 for expansion

and is consideration, 3 alternatives;

i) Debt is 16%
106
ii) Preference shares with a 16% dividend

iii) The sale of ordinary shares at $20 per share

The company is expected an EBIT of $200.000 per year and its income tax rate is 40%.

Required :
Calculate EPS under 3 options and recommend which option should be chosen.

Figures 000’s

Equity DEBT Preference

EBIT 2.000.000 2.000.00 2.000.000

0

Less interest / 640.000 /

EBT 2.000.000 1.360.00 2.000.00

0

Less 40%(tax) 800.000 544.000 800.000

EAT 1.200.000 816.000 1.200.000

Les pref. Dividend / / 640.000

Earnings for equity 1.200.000 816.000 560.000

N0 of Equity share 400.000 200.000 200.000

EPS 3 4.08 2.8

Conclusion; the company should go for debt financing because it maximizes earnings .

The indifference chart for example one above

EPS
107
6-

5– debt

4–
Equity
3–

Indifference point
2 -

1-

120
100 200 240 300 400 500 600 700 800 E.B.T(000)

108
 109

Under the equity option, a minimum EBIT of zero has to be earned to get an EPS of zero. This is
because under this option, there are no fixed interest charges.

For each financing option, a straight line is drawn on the indifference chart by joining
the two points. One point should show EPS under any hypothetical EBIT (800.000) in
our example. The second point should represent the minimum EBIT required to get an
EPS of zero. In our example the two points selected for equity for equity option are (EPE
2.4, EBIT 800.000) and (EPS 0, EBIT 0). The two points for the debts are (EPS 4.08, EBIT
800.000) and (EPS 0, EBIT 120.000). The point at which the two lines intersect is known as
the indifferent point. In our example it is an EBIT of (240.000).

Decision

As the chart' shows, the debt option will be better for any EBIT above 240.000 and the
equity option will be better for any EBIT below 240.000. At 240.000 the investor is
indifferent between equity and debt financing i.e why it is considered the indifferent point.

Mathematical derivation of the indifference point

The indifference point can be calculated by solving the following equation. Let EBIT*
represent EBIT at indifference point.

EBIT∗(0.6)(1−t)
=¿ ¿
s1

EBIT∗(0.6)
=¿ ¿
200000

EBIT∗¿ 0.6 EBIT∗−72.000

( 0.6 ) = ¿
200.000 100.000

100.000(0.6 EBIT*) = 200.000(0.6EBIT*- 72.000)

60.000 EBIT = 120.000 EBIT-14.400.000.000

60.000 EBIT*-120.000 EBIT = -14.400.000.000

14.400.000 .000
EBIT* =
60.000

EBIT* = 240.000

109
 110

CHAPTER TEN: DIVIDEND DECISION

Introduction

Dividend is the return on share investment. In this topic, we are going to look at the relevance
or irrelevance of dividend decision, the factors that companies considers to decide on dividend
policy and finally, we will look at dividend pay out policy (should dividend per share,
fluctuate or remain constant?) given the earnings (profit).

Relevance or the irrelevance of the dividend decision

a) The Irrelevance Theory

According to this theory, share holders are indifferent between paying cash

dividend or retaining profits for further investment. Even if the company retains all
profits the share holder will not border because they know it will lead to a higher future
profile and there will be no negative effect on share prices ..

b) The Relevance Theory

This theory contains that the dividend decision cannot be a residual or passive

decision because of their following reasons;

Resolution of uncertainty; cash dividend resolves uncertainty about future profits

and dividend as saying goes " A bird in hand is worth two in the bush"

Cash for current liquidity needs; some shareholders like retired people need

cash on a regular basis to meet their day to day financial exigencies and because

of this, dividend must be paid.

Personal Taxes; shareholders have to pay taxes from income received as cash dividends,
especially capital gains tax which is the tax on an increase in the value of shares from the

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time they arc acquired to the lime they are sold. it eau also be a tax on realised profits on long-
tenn investment.

Lack of perfect knowledge; share holders are not perfectly informed about the activities in the
enterprise and only the payment of dividend will be proof that profits were truly earned.

Transaction cost: share holders have to pay brokerage on the buying ans selling of share, but
according to irrelevance theory, it assume that transaction cost is NIL.

Control; the irrelevance theory assumes a person can sell part of his share to get liquid cash but
this reduces the percentage of share holding or ownership control over the company. The share
holders may like to do so.

Factors considered in deciding dividend policy by companies;

1) Investors need for liquidity

2) Good investment opportunities
3) Tax considerations
4) Company policy about stability of dividend
5) Government rules(legislation)

Dividends payout policy

Dividend pay out policy refer to what portion of earnings are being paid out as
dividend. Companies have three options; ·

Some companies may decide to pay dividend per share, which remain constant or

stable year alter year even when earnings keep on fluctuating (stable D.P.S).

Others may pay dividend at a fixed proportion of earnings so that D.P.S will rise or fall as
earnings arc rising and falling.

Some companies may treat dividend as a residual policy, depending on the

availability of investment opportunities.

NB: Application Exercise

A company has 1.000.000 ordinary share holders and has made the following earning over four
years as well as investment requirement over the same time period.
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Years/items Year 1 Year 2 Year 3 Year 4

Earnings (m$) 15 3 4 6

Investment required 4 4 4 3

Case 1, residual Dividend policy

Year Earnings Investment D.P.S External borrowing

1 5m 4m 2.5 1.5m

2 3m 4m Nil 1m

3 4m 4m Nil Nil

4 6m 3m 3 Nil

Case 2, Dividends payout; 50% of earnings

Year Earnings Investment D.P.S External borrowing

1 5m 4m 2.5 1.5m

2 3m 4m 1.5 2.5m

3 4m 4m 2 2m

4 6m 3m 3 Nil

Case 3, stable D.P.S.$2 per share

Year Earnings Investment D.P.S External borrowing

1 5m 4m 2 1m

2 3m 4m 1 3m

3 4m 4m 2 2m

4 6m 3m 2 Nil

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Revision exercise

The alpha & Ben company expects to generate the following net income and to have the following
capital expenditure during the next five years (the figures in the table are in thousands of dollars)

Years Net income Capital expenditure

1 2,000 1,000

2 1,500 1,500

3 2,500 2,000

4 2,300 1,500

5 1,800 2,000

The company current bas 1,000,000 shares of common stocks (ordinary shares)
outstanding and pays a dividend of $1 per share.

Required;

a) Determine the dividend per share and external financing required in each year if
dividend policy is treated as a residual decision.

b) Determine the amount of external financing in each year that will be necessary if the present
dividend per share is maintained.

c) Determine dividend per share and the amount of external financing that would be
necessary if the dividend pay out ratio of 50% is maintained.

2} Briefly discus the main argument for and against the irrelevance of dividend decision. What
factors influence a firm's dividend policy?

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CHAPTER ELEVEN: FINANCIAL ANALYSIS AND PLANNING

A1) Introduction

Ratios are used on a daily basis in many domains of life. We buy cars based on the consumption
of fuel per Km. we can also evaluate a football player by the number of kilometers he covers
in a football match in relation to the team' s average. These are ratios constructed to judge
comparative performance. ./

A2) Definition

Financial ratios are used to weigh and evaluate the operating performance of a firm white
an absolute value such as $100.000 earnings may appear satisfactory. its acceptability can
only be measured in relation to other values. In order words, ratio analysis is an
examination of accounting data by relating one figure to another. This

gives room for more meaningful interpretation of the data and the identification of trends.

Ratio analysis in an enterprise is carried out with the use of financial account like

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the income statement (P and L) and the balance sheet, These statements are used for three main
reasons;

1 Financials control

2 Planning

3 Accountability

Types of ratios

Ratios are classified commonly as

1) Profitability ratio; they are used to measure he firms returns on its investment. There are 3 main
types of profitability ratios;

net income
Profit margins measured as
sales

net income net income sales

Returns on assets/investment/capital employed measures as ∨n ×
total asset sales total asset

Return on equity(ordinary share) measured as

net income return on asset (investment )

∨n
ordinary shares ¿¿

2) Asset Utilization Ratios or Activity Ratios; it measures how productively a firm is using its
asset. This ratio also analyses how efficient debtors and inventories are managed.
Inventories and debtors are required for supporting the firm's sales activity, but too much or
too little inventory may be harmful to the firm. If there is too much investment, the firm
is losing out on the return that it could have earned if the excess funds had been invested
elsewhere. We will examine five ratios on asset utilization,

Receivable turn over = slaes ¿ ¿

account Recievable
Average collection period =
average daily credit sale

cost of goods sold sales

Inventory turnover = ∨
inventory inventory

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sales
Fixed Asset turn over =
¿ assats

sales
Total Asset =
total assts

Liquidity ratios; they measure how easily a firm can have access to cash. They also explain
the ability of a company to meet its short term liabilities. Current liabilities are payable
in the short term and it should be possible for the company to pay for these
liabilities without disposing off fixed assets and without disrupting the normal flow of
the business. The following are liquidity ratios:

current asset
Current ratios =
current liabilities

NB: Text books recommend a current ratio of 2.0, but it depends on the nature of the
business. When a company has a fluctuation in sales activities, the current ratio should be 2 but
when the company has a steady flow of cash, the current ratio can be less than 2 .

current asset
Acid Test Ratio(quick ratio) =
current liabilities

NB: In this ratio, inventories are deducted from the current assets because they are 1

considered the least liquid current asset. They are considered least liquid because they have
to be converted into finished goods before they can be sold out. If the inventories are
finished goods, they have to be sold out first and some may take the form of debtors before,
the debtors arc converted into cash. Also, it may be difficult ta carry on with normal
business without inventories. A healthy company should have a quick ratio of at least one
which means that the company should be able to pay its current liabilities without selling
its inventory.

4) Gearing or leverage ratios:

They show how heavily the company is indebted. Here were going to examine the 2 ratios.

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total Debt
i) Debt to total asset =
total Assets
YBIT
ii) Time interest earned =
interest

Application exercise

Consider the following hypothetical financial statement (balance sheet) and income statement fo
ABC company in the last three years.

Financial statement of ABC Limited (figures are in 000’s of dollars)

Items Year 1 Year 2 Year 3

Cash 30 20 5

Debtors 200 260 290

Inventory 400 480 600

Net fixed Asset 800 800 800

Total Asset 1,430 1,560 1,695

Creditors 230 300 380

Short term loans 300 3100 365

Long term debtors 300 300 300

Share capital 100 100 100

Retained earnings 500 550 550

Total liabilities 1,430 1560 1,695

Brief income statement of P&L for ABC limited (Figures are in 000’s of dollars)

Items Year 1 Year 2 Year 3

Sales 4,000 4,300 3,800

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COGS 3,200 3,600 3,300

Net profit 300 200 100

NB: the company sales on term of 2 in 10 or 30days

required

calculate

a) The current ratio for 3 years

b) The acid test ratio for 3 years
c) Total Asset turn over ration

current Asset−Inventory
b) acid ration =
current liabilities

630−400
Acid test ratio Year 1 = =0.43
530

760−600
Acid test ratio Year 2 = =0.46
610

895−600
Acid test ratio Year 3 = =0.04
745

The company has a low and unsatisfied acid test ratio. In total, the company has a poor
performance on the management of liquidity.

sales
c) Total Asset Turn over ratio =
total assets

4,000
total asset turn over ratio Year 1 = =2.8׿
1,430

4,300
Total Asset turn over year 2 = =2.76׿
1,560

3,800
Total asset turn over Year 3 = =2.24׿
1,695

This ratio explains how well the company’s asset have been used during the year for generating
sales. The above results show that the asset turn over in ABC company is fairly good.
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REVISION QUESTIONS AND ANSWERS

1) The Trans-Pacific Utility Co.'s stock is expected to pay constant annual dividends of 2.50 frs per
share forever. If the discount rate for the stock is 9% per year,
a) what is the stock price today?
b) what is the expected stock price at the end of one year?

SOLUTIONS

a) P0 = D/r = 2.50/.09 = 27.78 since it is a perpetuity

b) P1 = present value at time 1 of D2 onwards. These future dividends are still a perpetuity of
2.50 frs. So the price at the end of the year is the same:
P1 = 2.50/.09 = 27.78 Frs
(For a constant growth stock, stock price grows at the same rate as dividends. When the
dividend growth rate is zero, the stock price does not grow either.)

2) Sam’s Spades Co. had earnings per share last year of 3.50 frs and they paid a dividend last year of
1.40 frs. Assume their payout ratio remains constant, and their ROE is also constant at 15%. If their
required return is 12% per year, what is the stock price today?

SOLUTIONS
Payout ratio = Do/EPS = 1.4/3.5 = 40%
Growth rate = Ploughback ratio x ROE = (1 - .4) * .15 = 9%
D0 = 1.40
D1 = Do(1+g)
= 1.40 *1.09 = 1.526
P0 = D1/(r – g) = 1.526/(.12 - .09) = 50.87 Frs

3) Bootle Investments is expected to pay the following dividends for the next three years:
Time 1 2 3
Dividend 0.90 1.05 1.16
After time 3, dividends will grow at a constant rate of 8% per year. If the required return on the stock
is 16% per year, what should the stock price be today?

SOLUTIONS

Treat D3 onwards as a growing perpetuity => P3 = D3( 1+g) = 1.16(1.08) = 15.66

R-g 0 .16 - 0.08
=> P0 = D1 + D2 + D3+p3 = 0.90 +h 1.05 + 1.16+ 15.66 = 12.33
1+r (1+r)2 1.163 1.16 1.162 1.163

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4) The Nkam.’s Corp shares are selling for 65 frs. Their dividend last year was 3.28 frs. If their
plowback ratio is 50% and ROE is 20%, what is the required return for the stock?

SOLUTIONS

The growth rate = Ploughback ratio x ROE = 0.5 *0 .2 = 10%

The next dividend = D1 = D0 * (1+g) = 3.28 * 1.1 = 3.608
Required return = (D1/P0) + g = 3.608/65 + .10 = 15.5508%

5) Ayuk Inc., being a growth company, currently reinvests all its earnings and does not pay any
dividends. It is expected to pay the following dividends over the next four years:
Time 1 2 3 4
Dividend 0 0 0.50 1.00
After time 4, dividends will grow at a constant rate of 6% per year. If the required return on the stock
is 14% per year, what should be the stock price today (time 0)?

SOLUTIONS

We can treat D5 onwards as a growing perpetuity

=> P4 = D5/(.14 - .06) = (1.00*1.06)/.08 = 13.25
The price today is then:
P0 = D3/1.143 + (D4 + P4)/1.144 = 0.50/1.143 + (1.00 + 13.25)/1.144 = 8.77

6) Pumpkins Corporation is expected to pay a dividend of 2.50 frs next year. Its dividends are
expected to grow at 8% for the next three years, and at a constant rate of 4% forever thereafter. What
is the price of its stock today, if the discount rate for the stock is 12%?

SOLUTIONS

D1 = 2.50
D2 = 2.50*1.08 = 2.70
D3 = 2.50*1.082= 2.916
D4 = 2.50*1.083= 3.149
D5 = 2.50*1.083*1.04 = 3.275
D6 = 2.50*1.083*1.042
etc.

Treat D5 onwards as a growing perpetuity => P4 = D5/(r - g) = 3.275/(.12 - .04) = 40.94

=> P0 = D1 + D2 + D3 + D4 + P4
1.12 1.122 1.123 1.124
= 2.5/1.12 + 2.7/1.122 +2.916/1.123 +(3.149+40.94)/1.124 = 34.48

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7) Big Stores Inc. has the following stream of expected future dividends. Initially, dividends will
decline as the company reinvests most of its earnings in new projects. From the fourth year onwards,
dividends will start to increase again, as the new projects start contributing profits.
Time 1 2 3 4 5 6
Dividend 1.60 1.40 1.30 2.00 2.50 3.00
After time 6, dividends will grow at a constant rate of 10% per year. If the required return on the stock
is 14% per year,
a) what price should the stock sell for today?
b) what is your expected return if you buy the stock today and hold it for four years?

SOLUTIONS

Treat D6 onwards as a growing perpetuity.

Then P5 = D6 = 82.25
.14 - .10
And P0 = D1 + D2 + D3 + D4 + D5 + P5
1.14 1.14 1.143 1.144 1.145

= 1.6 + 1.4 + 1.3 + 2 + 2.50 + 82.25 = 44.79

1.14 1.142 1.143 1.144 1.145
b) Your expected return will simply equal the required return, i.e. 14%.

8) Chariot Corp. generates a perpetuity of 8.50 Frs per year from its existing assets. Every year they
pay out 70% of these earnings, and reinvest the remaining 30% at a return of 15%. If their required
return is 12%,
a) What is their stock price?
b) How much of this is PVGO?
c) If they had no positive NPV investments, but they still maintained a payout ratio of 70%, how much
would they earn on their reinvestment? What growth rate would they have?

SOLUTIONS

a) Plowback ratio = 0.3

Growth rate = 0.3 * .15 = 4.5%
D1 = .7 * 8.50 = 5.95
P0 = D1/(r – g) = 5.95/(.12 - .045) = 5.95/.075 = 79.33
b) Existing assets generate a perpetuity, so PV(existing assets) = 8.5/0.12 = 70.83.
PVGO = P0 - PV(existing assets) = 79.33 - 70.83 = 8.50
c) With no positive NPV investments, the return they earned on their reinvestment would have
to be the same as the required return, namely 12%.
The growth rate would be .03 * .12 = 3.6%
[We can verify that at this growth rate, the stock price just equals PV(existing assets):
5.95/(.12 - .036) = 5.95/.084 = 70.83]

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9) CSI has a 10% ROE and reinvests 40% of its earnings each year. Their expected dividend next year
is 4 frs, and the stock is selling for 100 frs today.
a) What is the expected return on the stock?
b) What is the expected EPS next year?
c) What proportion of today’s stock price consists of PVGO?
d) Suppose CSI is able to scale up the size of their positive NPV investment opportunities. Instead of
reinvesting 40% of their earnings each year they are able to reinvest 60% instead (still at a 10% ROE).
How does this affect their stock price today? What is the percentage increase in PVGO?

SOLUTIONS
a) The expected return = required return = D1/P0 + g = 4/100 + .4 * .1 = 8%
b) EPS1 = D1/payout ratio = 4/(1 - .4) = 6.6667
c) PV(existing assets) = EPS1/r = 6.6667/.08 = 83.33
P0 = D1/(r – g) = 4/(.08 - .04) = 100
PVGO = 100 – 83.33 = 16.67
d) The growth rate becomes .6 * .1 = 6%
P0 = 4/(.08 - .06 = 200
PVGO = 200 – 83.33 =116.67
The stock price doubles; percentage increase in PVGO = 100/16.67 = 600%.
(A relatively small improvement in positive NPV investment opportunities can have a
pretty dramatic impact on the stock price!)

10) Muyuka Paper Works is expected to pay a dividend of 2.22 frs next year. It has a dividend yield of
8%. Each year it pays out 65% of its earnings; on the 35% that is reinvested, it earns a return of 16%.
a) What is MPW’s growth rate?
b) What is their required return?
c) What is the stock price today?
d) How much of this is the PV of existing assets, and how much is PVGO?

SOLUTIONS
a) g = plowback ratio * ROE = .35*.16 = 5.6%
b) r = div yield + g = .08 + .056 = 13.6%
c) P0 = D1/(r – g) = 2.22/(.136 - .056) = 27.75
(alternatively, div yld = D1/P0 => P0 = D1/ div yld = 2.22/.08 = 27.75)
d) PV(existing assets) = EPS/r
Since the dividend of 2.22 is 65% of the earnings, EPS = 2.22/.65 = 3.415
PV(existing assets) = EPS/r = 3.415/.136 = 25.113
PVGO = P0 - PV(existing assets) = 27.75 – 25.113 = $2.64

(alternatively, first compute the growth rate if retained earnings are invested at zero NPV: .35
* .136 = 4.76%
PV(existing assets) = stock price if retained earnings are invested at zero NPV = 2.22/(.136-.0476)
= 25.113)
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11) Buea Ltd. is a start-up firm with a required return of 15%. They will invest 40 frs per share today,
and earn 30% on this investment the first year. For two years, they will pay out 10% of their earnings
and retain 90%. And they will continue to earn 30% on their assets. However after two years, the
payout ratio will increase to 60% and the return on assets will drop to 20% (all assets, old and new).
These rates will stay constant forever.
a) Make a table showing the firm’s dividend per share for the first 5 years
b) Compute the value of Newbie’s shares today
c) What is Newbie’s PVGO?

(Clarifications and hints:

What is invested at time 0 earns 30% for 2 years and then 20% thereafter. What is invested at time 1
earns 30% for one year and then 20% thereafter? What is invested at time 2 and later earns 20%
forever.
Buea’s existing assets today consist of the initial investment of $40 per share. In other words, “today” is
time 0, after this investment has been made.
PV of the existing assets is the PV of the earnings expected to be generated by the existing assets. This has
to be computed given that the future earnings from the existing assets are not a perpetuity.)

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SOLUTIONS

11 a) Follow table 4.3 from the text:

Time 1 Time 2 Time 3 Time 4
Equity 40 40 + 12*.9 = 50.8+15.24*.9=64.52 64.52+12.90*.4=69.68
50.8
EPS 40*.3 = 12 50.8*.3 = 15.24 64.52*.2=12.90 69.68*.2=13.94
Div. 12*.1 =1.2 15.24*.1=1.524 12.90*.6=7.742 13.94*.6=8.36
g 27% 408% 8%
If you continue the table for time 5, equity will be 69.68 + 13.94*.4 = 75.25
EPS will be 75.25*.2 = 15.05
The dividend will be 15.05*.6 = 9.03, which is again an 8% growth rate. After time 4, dividends
settle down to constant growth at 8% (which is just the ROE of 20% times the plowback ratio of
40%)
b) Treat D4 onwards as a growing perpetuity => P3 = D4/(r - g) = 8.36/(.15 - .08) = 119.45
=> P0 = D1 + D2 + D3 + P3
1.15 1.152 1.153
= 1.2/1.15 + 1.524/1.152 + (7.742 + 119.45)/1.153 = 85.82

c) The earnings generated by the time 0 investment are as follows:

EPS1 = EPS2 = 40*.3 = 12
EPS3 onwards = 40*.2 = 8
So EPS3 onwards constitutes a perpetuity; the PV of these earnings at time 2 is 8/.15
PV0 of existing assets (per share) = 12/1.15 + 12/1.152 + (8/.15)*(1/1.152) = 59.84
PVGO = P0 - PV0 of existing assets = 85.82 – 59.84 = 25.99

12) Discounted cash flow valuation is based upon the notion that the value of an asset is the present
value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those
cash flows. Specify whether the following statements about discounted cash flow valuation are true
or false, assuming that all variables are constant except for the variable discussed below:

A. As the discount rate increases, the value of an asset increases.

B. As the expected growth rate in cash flows increases, the value of an asset increases.
C. As the life of an asset is lengthened, the value of that asset increases.
D. As the uncertainty about the expected cash flows increases, the value of an asset increases.
E. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value.
Answers
A. False. The reverse is generally true.
B. True. The value of an asset is an increasing function of its cash flows.
C. True. The value of an asset is an increasing function of its life.
D. False. Generally, the greater the uncertainty, the lower is the value of an asset.
E. False. The present value effect will translate the value of an asset from infinite to finite
terms.

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13) There are two approaches to valuation. The first approach is to value the equity in the firm. The
second approach is to value the entire firm. What is the distinction? Why does it matter?

Answers

When equity is valued, the cash flows to equity investors are discounted at their cost (the cost
of equity) to arrive at a present value, which is the value of the equity stake in the business.

When the firm is valued, the cash flows to all investors in the firm (including equity investors,
lenders and preferred stockholders) are discounted at the weighted average cost of capital to
arrive at a present value, which equals the value of the entire firm (generally much higher
than the value of just the equity stake.)

The distinction matters for two reasons:

(1) Mismatching cash flows and discount rates can cause significant errors in valuation.

(2) Not recognizing what the present value of the cash flows measures can also lead to
misinterpretations. For instance, if the present value of cash flows to the firm is treated as the
value of equity, there is an obvious problem.

14) The following are the projected cash flows to equity and to the firm over the next five years:

CF to
Year Int (1-t) CF to Firm
Equity
1 $250.00 $90.00 $340.00
2 $262.50 $94.50 $357.00
3 $275.63 $99.23 $374.85
4 $289.41 $104.19 $393.59
5 $303.88 $109.40 $413.27
Terminal
3,946.50 6,000.00
Value
(The terminal value is the value of the equity or firm at the end of year 5.)
The firm has a cost of equity of 12% and a cost of capital of 9.94%. Answer the following
questions:
A. What is the value of the equity in this firm?
B. What is the value of the firm?
Solutions

A. PV of CF to Equity = 250/1.12 + 262.50/1.12^2 + 275.63/1.12^3 + 289.41/1.12^4 +

(303.88+3946.50)/1.12^5 = 3224 frs

B. PV of CF to Firm = 340/1.0994 + 357/1.0994^2 + 374.85/1.0994^3 + 393.59/1.0994^4 +

(413.27+6000)/1.0994^5 = 5149 frs

15) Why might discounted cash flow valuation be difficult to do for the following types of firms?

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A. A private firm, where the owner is planning to sell the firm.

B. A biotechnology firm, with no current products or sales, but with several promising product
patents in the pipeline.
C. A cyclical firm, during a recession.
D. A troubled firm, which has made significant losses and is not expected to get out of trouble for a
few years.
E. A firm, which is in the process of restructuring, where it is selling some of its assets and
changing its financial mix.
F. A firm, which owns a lot of valuable land that is currently unutilized.

Solutions

A. It might be difficult to estimate how much of the success of the private firm is due to the
owner's special skills and contacts.

B. Since the firm has no history of earnings and cash flow growth and, in fact, no potential for
either in the near future, estimating near term cash flows may be impossible.

C. The firm's current earnings and cash flows may be depressed due to the recession. Other
measures, such as debt-equity ratios and return on assets may also be affected.

D. Since discounted cash flow valuation requires positive cash flows some time in the near
term, valuing troubled firms, which are likely to have negative cash flows in the foreseeable
future, is likely to be difficult.

E. Restructuring alters the asset and liability mix of the firm, making it difficult to use
historical data on earnings growth and cash flows on the firm.

F. Unutilized assets do not produce cash flows and hence do not show up in discounted cash
flow valuation, unless they are considered separately

16) An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow
valuation, to value stocks, because he does not like making assumptions about fundamentals -
growth, risk, and payout ratios. Is his reasoning correct?

Answer

No. Any time a multiple is used, there is implicit, in that multiple, assumptions about growth,
risk

19) Which of the following is the best description of the free cash flow to equity?
A. It is the cash that equity investors can take out of the firm.
B. It is the dividend that is paid to stockholders.
C. It is the cash that equity investors can take out of the firm after financing investment needed to
sustain future growth.
D. It is the cash left over after meeting debt payments and paying taxes.
E. None of the above.
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solution

C. It is the cash that equity investors can take out of the firm after financing investment
needed to sustain future growth.

20) Answer true or false to the following statements.

A. The free cash flow to equity will always be higher than the net income of the firm, because
depreciation is added back.
B. The free cash flow to equity will always be higher than the dividend.
C. The free cash flow to equity will always be higher than cash flow to the firm, because the latter
is a pre-debt cash flow.
D. The entire free cash flow to equity cannot be paid out as a dividend because some of it has to be
invested in new projects.

Solutions
A. False. Capital expenditures may be greater than depreciation.
B. False. The dividends can exceed the free cash flow to equity.
C. False. The FCFF is a pre-debt cash flow. In the long term, it can be equal to, but it cannot
be lower than the FCFE. In any one year, however, the FCFE can exceed the FCFF is there
are substantial new debt issues.
D. False. The free cash flow to equity is after capital expenditures

21) Answer true or false to the following statements relating to the effect of inflation on cash flows
and value.

A. Discounting nominal cash flows at the real discount rate will result in too low an estimate of
value.
B. Dicounting real cash flows at the nominal discount rate will result in too low an estimate of
value.
C. If done right, the value estimated should be the same if either real cash flows are discounted at
the real discount rate or nominal cash flows are discounted at the nominal discount rate.
D. If companies can raise prices at the same rate as inflation, their value should not be affected by
changes in the inflation rate.
E. Inflation should increase the value of stocks because it increases expected future cash flows.

Solutions
A. False. It will result in too high a value.
B. True.
C. True.
D. False. There might be loss of value due to loss of depreciation tax benefits.
E. False. The discount rate also goes up.

22) Santa manufactures, markets, and services automated teller machines in the Cameroon. The
following are selected numbers from the financial statements for 1992 and 1993 (in millions
Francs):

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1992 1993
Revenues 544.0 620.0
(Less) Operating Expenses (465.1) (528.5)
(Less) Depreciation (12.5) (14.0)
= Earnings before Interest and Taxes 66.4 $77.5
(Less) Interest Expenses (0.0) (0.0)
(Less) Taxes (25.3) (29.5)
= Net Income 41.1 48.0
Working Capital 175.0 240.0

The firm had capital expenditures of 15 million frs in 1992 and 18 million frs in 1993. The working
capital in 1991 was 180 million frs.

A. Estimate the cash flows to equity in 1992 and 1993.

B. What would the cash flows to equity in 1993 have been if working capital had remained at the
same percentage of revenue it was in 1992.

Solutions

A. FCFE in 1992 = 41.10 + 12.50 - 15 - (175 - 180) = 43.60 million

FCFE in 1993 = 48 + 14 - 18 - (240 - 175) = - 21 million

B. Working Capital as Proportion of Revenues: 1992 = 175/544 = 32.17%

Change in Revenues in 1993 = 620 - 544 = 76

FCFE in 1993 = 48 + 14 - $18 - (175/544) * (620 - 544)

= 19.55 million

23) SHINE s is a full-service truck leasing, maintenance, and rental firm with operations in North
America and Europe. The following are selected numbers from the financial statements for 1992
and 1993 (in million frs).

1992 1993
Revenues 5,192.0 5,400.0
(Less) Operating Expenses (3,678.5) (3848.0)
(Less) Depreciation (573.5) (580.0)
= EBIT 940.0 972.0
(Less) Interest Expenses ($170.0) (172.0)
(Less) Taxes (652.1) (670.0)
= Net Income 117.9 130.0
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Working Capital 92.0 <370.0>

Total Debt 2,000 mil 2,200 mil

The firm had capital expenditures of 800 million frs in 1992 and 850 million in frs in1993. The
working capital in 1991 was 34.8 million frs, and the total debt outstanding in 1991 was 1.75 billion
frs. There were 77 million shares outstanding, trading at 29 frs per share.

A. Estimate the cash flows to equity in 1992 and 1993.

B. Estimate the cash flows to the firm in 1992 and 1993.

C. Assuming that revenues and all expenses (including depreciation and capital expenditures)
increase 6%, and that working capital remains unchanged in 1994, estimate the projected cash flows
to equity and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)

D. How would your answer in (c) change if the firm planned to increase its debt ratio in 1994 by
financing 75% of its capital expenditures (net of depreciation) with new debt issues?

Solutions

A. FCFE1992 = 117.9 + 573.5 - 800 - (92 - 34.8) + (2000-1750) = 84.20 million

FCFE1993 = $130 + $580 - $850 - (-370 - 92) + (2200 - 2000) = 522 million

B. FCFF1992 = 117.9 million + 170 (1 - (652/770)) + 573.5 - $800 - (92 - 34.8) = - 139.75
million

(The tax rate is extraordinarily high = 652/770; the taxable income is 770 million (940 - 170))

FCFF in 1993 = 130 million + 172 (1 - (670/800)) + 580 - 850 - (-370 - 92) = 349.95 million

C. Debt Ratio = 2200 million/(2200 million + 77 * 29) = 49.63%

1994 projection
Net Income = 137.80
- (1 - 0.4963) * (850 - 580) * 1.06 = 144.16
FCFE = -6.36

D. (Also in millions)

Net Income = 137.80

- (1 - 0.75) * (850 - 580) *
71.55
1.06 =
FCFE = 66.25

24) Occidental Petroleum produces and markets crude oil. The following are selected numbers from
the financial statements for 1992 and 1993 (in millions frs).
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1992 1993
Revenues 8,494.0 9,000.0
(Less) Operating Expenses (6,424.0) (6,970.0)
(Less) Depreciation (872.0) (860.0)
= EBIT 1,198.0 1,170.0
(Less) Interest Expenses (510.0) (515.0)
(Less) Taxes (362.0) (420.0)
= Net Income 326.0 235.0
Working Capital (45.0) (50.0)
Total Debt 5.4 billion 5.0 billion

The firm had capital expenditures of 950 million frs in 1992 and 1 billion frs in 1993. The working
capital in 1991 was 190 million frs, and the total debt outstanding in 1991 was 5.75 billion frs.
There were 305 million shares outstanding, trading at 21 frs per share.

A. Estimate the cash flows to equity in 1992 and 1993.

B. Estimate the cash flows to the firm in 1992 and 1993.
C. Assuming that revenues and all expenses (including depreciation and capital expenditures)
increase 4%, and that working capital remains unchanged in 1994, estimate the projected cash flows
to equity and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)

D. How would your answer in (c) change if the firm planned to reduce its debt ratio in 1994 by
financing 100% of its capital expenditures (net of depreciation) with new equity issues?

Solutions

1991 1992 1993 1994 1994

(no debt)
Revenues 8,494 9,000 9,360 9,360
- Operating Expenses 6,424 6,970 7,249 7,249
- Depreciation 872 860 894 894
= EBIT 1,198 1,170 1,217 1,217
- Interest Expenses 510 515 536 536
- Taxes 362 420 437 437
= Net Income 326 235 244 244
+ Depreciation 872 860 894 894
- Capital Expenditures 950 1,000 1,040 1,040
- Working Capital (235) (5) (0) (0)
+ Net Debt Issues (350) (400) 63 0
=FCFE 133 (300) 162 98
+ Interest Expenses (1-t) 242 185 202 202
- Net Debt Issues (350) (400) 63 0
=FCFF 725 285 301 300

Working Capital 190 (45) (50) (50) (50)

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Total Debt 5,750 5,400 5,000

Debt Ratio 43.84%

Tax Rate 52.62% 64.12% 64.12% 64.12%

To get the new debt issues in 1994, take 43.84% of the net capital expenditures in that year
(1040 - 894)

25) Watts Industries, a manufacturer of valves for industrial and residential use, had the following
projected free cash flows to equity per share for the next five years , in nominal terms.

Terminal
Year FCFE/sh
Value
1 1.12
2 1.25
3 1.40
4 1.57
5 1.76 23.32
The terminal price is based upon a stable nominal growth rate of 6% a year after year 5. The
discount rate, based upon financial market rates, is 14%, and the expected inflation rate is 3%.

A. Estimate the value per share, using nominal cash flows and the nominal discount rate.
B. Estimate the value per share, using real cash flows and the real discount rate.
Solutions
Terminal
Year FCFE/share Real CF
Value
1 1.12 1.09
2 1.25 1.18
3 1.40 1.29
4 1.57 1.40
5 1.76 23.32 21.63

Real Cash Flow = Nominal Cash Flowt/(1.03)t

A. Present Value = 1.12/1.14 + 1.25/1.142 + 1.40/1.143 + 1.57/1.144 + (1.76 + 23.32)/1.14 =

$16.84

B. Real Discount Rate = 1.14/1.03 - 1 = 10.68%

Present Value =1.09/1.1068 + 1.18/1.10682 + 1.29/1.10683 + 1.40/1.10684 + (21.63)/1.10685 =

$16.84

(Use real discount rates on real cash flows.)

Question 8 - After-tax and Pre-tax Valuation

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26) Consider the example of Kuma Corporation. The stock is trading at 37 frs per share currently.
The expected dividends, prior to personal taxes, as well as the expected terminal price, are given
below:

Expected Terminal
Year
DPS Price
1 0.67
2 0.75
3 0.84
4 0.94
5 1.06 62.79

The expected return, prior to personal taxes, on Polaroid is 13%, of which 1.81% is expected to
come from dividends. An investor facing a tax rate of 36% on dividends and 25% on capital gains
is considering investing in the stock.

A. What is the expected return, after personal taxes, to this investor?

B. What are the expected dividends and terminal price, after personal taxes, to this investor?
C. What is the value of the stock, using these after-personal-tax cash flows and discount rates?
D. What is the value of the stock, using the pre-personal-tax cash flows and discount rates?

Solutions

A. Expected Return = Expected Dividend Yield * (1 - 0.36) + Expected Price Appreciation * (1

- 0.25) = 0.0181 * 0.64 + 0.1119 * 0.75 = 9.55%

B.

Before Taxes After Taxes

Expected Terminal Expected Terminal
Year
DPS Price DPS Price
1 0.67 0.43
2 0.75 0.48
3 0.84 0.54
4 0.94 0.60
5 1.06 62.79 0.68 56.34

Terminal price after taxes = 62.79 - (62.79 - 37.00) * 0.25 = 56.34.

C. Present Value = 0.43/1.0955 + 0.48/1.0955^2 + 0.54/1.0955^3 + 0.60/1.0955^4 + (0.68 +

56.34)/1.0955^5 = 37.76

D. Present Value = 0.67/1.13 + 0.75/1.13^2 + 0.84/1.13^3 + 0.94/1.13^4

+ ($1.06 + $62.79)/1.13^5 = $36.99

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27) The terminal value in a capital budgeting project is generally much lower than the initial
investment. The terminal price in a stock valuation is generally much higher than the initial
investment. How would you explain the difference?

Solutions

A capital budgeting project generally has a finite life. Consequently it loses value over time. A
stock has an infinite life. It generally increases in value over time, both as a consequence of
inflation and real growth.

28) kum Ltd, a leading manufacturer of healthcare products, had a return on equity in 1992 of
31.4%, and paid out 36% of its earnings as dividends. It earned a net income of 1,625 million frs on
a book value of equity of 5,171 million frs. As a consequence of healthcare reform, it is expected
that the return on equity will drop to 25% in 1993 and that the dividend payout ratio will remain
unchanged.

A. Estimate the growth rate in earnings based upon 1992 numbers.

B. Estimate the growth rate in 1993, when the ROE drops from 31.4% to 25%.
C. Estimate the growth rate after 1993, assuming that 1993 numbers can be sustained.

Solutions

A. Retention Ratio = 64%

Return on Equity = Net income/ Book value of equity =1625/5171 = 31.4%

Expected Growth Rate = Retention ration x ROE = 0.64 * 31.4% = 20.10%

B. Growth Rate in 1993 = (Book value of Equity (r-g)/net income ) + retention rate x New
ROE

=( 5,171 * (.25 -.314)/ $1,625) + 0.64 * 0.25 = -4.37%

C. Growth Rate After 1993 = 0.64 * 0.25 = 16%

28) Ben LUKONG was, in the view of many observers, in serious need of restructuring in 1994. In
1993, the firm reported the following:

Net Income = 1,080 million FRS

Interest Expense = 550 million fRS
The firm also had the following estimates of debt and equity in the balance sheet:
Equity (Book Value) = 6,000 million FRS
Debt (Book Value) =$6,880 million FRS

The firm also paid out total dividends of 660 million FRS in 1993. The stock was trading at 63
FRS, and there were 330 million shares outstanding. (It faced a corporate tax rate of 40%.) Lukong
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had a beta of 1.10. Analysts believe that Lukong could take the following restructuring actions to
improve its financial strength:

i) It could sell its chemical division, which has a total book value of assets of 2,500 million frs and
has only 100 million frs in earnings before interest and taxes.

ii) It could use the cash to pay down debt and improve its bond rating (leading to a decline in the
interest rate to 7%).

iii) It could reduce the dividend payout ratio to 50% and reinvest more back into the business.

A. What is the expected growth rate in earnings, assuming that 1993 numbers remain unchanged?

B. What is the expected growth rate in earnings, if the restructuring plan described above is put into
effect?

C. What will the beta of the stock be, if the restructuring plan is put into effect?

Solutions

A. Retention Ratio = 1 - 660/$1080 = 0.3889

Return on Assets = (1080 + $550 * (1 - 0.4))/(6000 + 6880) = 10.95%

Debt/Equity Ratio = (6880/6000) = 1.14

Expected Growth Rate: = 0.3889 (10.95% + 1.14 (10.95% - (550/6880) * (1 - 0.4)) = 7.00%

B. Retention Ratio = 50%

Total Assets = 6000 + 6880 - 2500 = 10.380.

New Return on Assets = (1020 + 550 * (1 - 0.4))/10380 = 13.01%

(The earnings before interest and taxes goes down by $100. The earnings after taxes will drop
by $60. Note that interest expenses will be lower after debt is paid off, but the net income will
go up by an equivalent amount.)

New Debt Equity Ratio = (4380/6000) = 0.73

New Expected Growth Rate = 0.50 (13.01% + 0.73 (13.01% - 7%*(1 - 0.4))) = 9.72%

(The growth rate next year will be much higher as a result of the shift in the return on equity,
but the long term growth rate will now be 9.72%)

C. Beta Before Change = 1.10

Unlevered Beta = 1.10/(1 + (6880/(330 * $63)) * (1 - 0.4)) = 0.9178

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(Use market value of equity for this calculation)

Beta After Change = 0.9178 * (1 + (4380/(330 * $63)) * (1 - 0.4)) = 1.0

29) Philip Morris, a leading consumer products company, was forced to cut prices on its Marlboro
brand of cigarettes in early 1993 to combat loss of sales to generic competitors. You are attempting
to assess the effects on expected growth as a consequence.

In 1992, Philip Morris had earnings before interest and taxes of $10 billion on sales of $60 billion.
The firm also had total assets of $30 billion in that year. As a consequence of its price cuts in 1993,
the pre-interest profit margin is expected to decline to 9%. The debt/equity ratio is expected to
remain unchanged at 1.00, and the interest rate will remain at 6.5%. (The tax rate is 36%.) Philip
Morris pays out 65% of its earnings as dividends.

A. Based upon 1992 numbers, what is the expected growth rate in earnings?
B. Assuming that the asset turnover ratio remains unchanged, what will the growth rate in earnings
be after the price cuts in 1993?
C. How much will the asset turnover ratio have to increase for Philip Morris to return to the growth
rate it had in 1992?
Solutions
A. Pre-Interest, After-Tax Profit Margin = EBIT (1-T)/Sales = 10 * (1 - 0.36)/ 60 = 10.67%
Asset Turnover = Sales/Total Assets = 60/30 = 2
Return On Assets = 0.1067 * 2 = 0.2134 Or 21.34%
Retention Ratio = 35%
Expected Growth Rate = 0.35 (0.2134 + 1 (0.2134 - 0.065 * 0.64)) = 13.48%
B. Pre-Interest, After-Tax Profit Margin = 9.00%
Return on Assets = 0.09 * 2 = 18%
New Growth Rate = 0.35 (0.18 + 1 (0.18 - 0.065 * 0.64))= 11.14%
C. Break-Even Asset Turnover = 0.2134/0.09 = 2.37

29) Computer Associates makes software that enables computers to run more efficiently. It is still in
its high-growth phase and has the following financial characteristics:

Return on Assets = 25%

Dividend Payout Ratio = 7%
Debt/Equity Ratio = 10%
Interest rate on Debt = 8.5%
Corporate tax rate = 40%
It is expected to become a stable firm in ten years.

A. What is the expected growth rate for the high-growth phase?

B. Would you expect the financial characteristics of the firm to change once it reaches a steady
state? What form do you expect the change to take?

C. Assume now that the industry averages for larger, more stable firms in the industry are as
follows:

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Industry Average Return on Assets = 14%

Industry Average Debt/Equity Ratio = 40%
Industry Average Interest Rate on Debt = 7%
Industry Average Dividend Payout ratio = 50%
D. What would you expect the growth rate in the stable growth phase to be?

Solutions
A. Expected Growth Rate = 0.93 (25% + 0.10 (25% - 8.50% * (1 - 0.4)) = 25.10%
B. The following would be the expected changes :
(1) ROC will decline as the firm gets larger and the marginal projects are no longer as
lucrative.
(2) Dividend payout ratio will increase.
(3) Debt/Equity ratio will increase as the firm gets larger and safer.
(4) The interest rate on debt will decline for the same reasons.
C. Expected Growth Rate = 0.5 (0.14 + 0.4 (0.14 - 0.07 * (1 - 0.4)) = 8.96%

30) The following are a number of valuation scenarios, where multiple estimates of growth are
available. Specify how you weight the different growth rates and why.

A. A cyclical firm, whose earnings have dropped significantly (historical growth rate is negative) as
a consequence of a recession, but which you believe has bottomed out and is in the process of
recovering. The firm is heavily followed by analysts, who have a good track record in forecasting
earnings growth.

B. A troubled firm, whose earnings have dropped significantly because of a combination of bad
luck and bad management, but which is now restructuring. You have fairly good information on the
form the restructuring will take and its expected impact. Analysts follow the firm, but their track
record is spotty.

C. A healthy firm, where the estimates of growth from history, analysts, and fundamentals are fairly
close.

D. A firm, which has a long and fairly reliable history of earnings growth, but which has just sold
off three divisions (comprising almost half of the market value of the firm). Analysts follow the
stock, but base forecasts primarily on historical growth.

Solutions

A. Weight analysts' forecasts the most, and historical growth rates the least (or not at all). In
estimating growth rates from fundamentals, use predicted values for the fundamentals, rather than
current values.

B. Use growth rates from fundamentals, and reflect the expected changes from the restructuring in
these fundamentals.

C. Weight all three growth rates equally.

D. Use fundamentals on the remaining divisions to predict growth.

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31) Respond true or false to the following statements relating to the dividend discount model.

A. The dividend discount model cannot be used to value a high growth company that pays no
dividends.
B. The dividend discount model will undervalue stocks, because it is too conservative.
C. The dividend discount model will find more undervalued stocks, when the overall stock market
is depressed.
D. Stocks that are undervalued using the dividend discount model have generally made significant
positive excess returns over long periods (five years or more).
E. Stocks which pay high dividends and have low price/earnings ratios are more likely to come out
as undervalued using the dividend discount model.
solutions
A. False. The dividend discount model can still be used to value the dividends that the
company will pay after the high growth eases.
B. False. It depends upon the assumptions made about expected future growth and risk.
C. False. This will be true only if the stock market falls more than merited by changes in the
fundamentals (such as growth and cash flows).
D. True. Portfolios of stocks that are undervalued using the dividend discount model seem to
earn excess returns over long time periods.
E. True. The model is biased towards these stocks because of its emphasis on dividends.
32) An analyst complains that the Gordon Growth Model yields absurd results. He presents several
problems that he has had with the model. Respond to each of these comments.
A. The model values stocks which do not pay dividends at zero.
B. The model sometimes yields negative values for stocks, when growth rates exceed the discount
rate.
C. The model yields absurdly high values for other stocks, where the discount rate is very close to
the growth rate.
D. No firm raises dividends by a fixed percent every year. The model's assumption is unrealistic
and the values obtained from it will not hold.
E. Since cyclical firms have earnings which go up and down, based upon economic conditions, the
model can never be used to value a cyclical firm.
solutions

A. A stock that pays no dividends is not a stable stock. The Gordon Growth model is not designed
to value such a stock. If a company with stable growth insists on not paying dividends, but
retains the FCFE, this FCFE can be used in the Gordon Growth model as the dividend.

B. A stable stock cannot have a growth rate greater than the discount rate, because no
company can grow much faster than the economy in which it operates in the Gordon Growth
Model. This upper limit on how high growth rates can go operates as a constraint in the
model.

C. This should not happen for a stable stock, for the same reasons stated above.

D. It is true that the model smooths out growth rates in dividends. In present value terms,
though, this smoothing effect cannot have a large effect on the value estimate obtained from
the model.

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E. The model requires that, in the long term, the growth rate for a firm is stable (close to the
growth rate in the economy). Thus, cyclical firms, which maintain an average growth rate
close to a stable rate, cyclical ups and downs notwithstanding, can be valued using this model.

33) Ameritech Corporation paid dividends per share of $3.56 in 1992, and dividends are expected
to grow 5.5% a year forever. The stock has a beta of 0.90, and the treasury bond rate is 6.25%.

A. What is the value per share, using the Gordon Growth Model?
B. The stock is trading for $80 per share. What would the growth rate in dividends have to be to
justify this price?
Solution

A. Cost of Equity = 6.25% + 0.90 * 5.5% = 11.20%

Value Per Share = $3.56 * 1.055/(.1120 - .055) = $65.89

B. $3.56 (1 + g)/(.1120 - g) = $80

Solving for g,

g = (80 * .112 - 3.56)/(80 + 3.56) = 6.46%

34) A key input for the Gordon Growth Model is the expected growth rate in dividends over the
long term. How, if at all, would you factor in the following considerations in estimating this growth
rate?

A. There is an increase in the inflation rate.

B. The economy in which the firm operates is growing very rapidly.
C. The growth potential of the industry in which the firm operates is very high.
D. The current management of the firm is of very high quality.

Solutions

growth rate. Whether the increase will be the same in both variables will depend in large part
on whether an increase in inflation will adversely impact real economic growth.

B. This should affect the estimation of a stable growth rate. A much higher stable growth rate
can be used for firms in economies which are growing rapidly.

C. An analyst has very limited flexibility when it comes to using the Gordon Growth model in
estimating growth. If the growth potential of the industry in which the firm operates is very
high, a growth rate slightly higher (1 to 2%) than the growth rate in the economy can be used
as a stable growth rate. Alternatively, a two-stage or three-stage growth model can be used to
value the stock.

D. Same as the answer to 3.

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35) Newell Corporation, a manufacturer of do-it-yourself hardware and housewares, reported

earnings per share of $2.10 in 1993, on which it paid dividends per share of $0.69. Earnings are
expected to grow 15% a year from 1994 to 1998, during which period the dividend payout ratio is
expected to remain unchanged. After 1998, the earnings growth rate is expected to drop to a stable
6%, and the payout ratio is expected to increase to 65% of earnings. The firm has a beta of 1.40
currently, and it is expected to have a beta of 1.10 after 1998. The treasury bond rate is 6.25%.

A. What is the expected price of the stock at the end of 1998?

B. What is the value of the stock, using the two-stage dividend discount model?
Solution

A. Expected Earnings Per Share in 1999 = $2.10 * 1.155 * 1.06 = $4.48

Expected Dividends Per Share in 1999 = $4.48 * 0.65 = $2.91

Cost Of Equity After 1999 = 6.25% + 1.1 * 5.5% = 12.30%

Expected Price at the End of 1998 = Expected DPS in 1999/(ke, 1999 - g)

= $2.91/(.1230 - .06) = $46.19

B.

Year EPS DPS

1994 $2.42 $0.79
1995 $2.78 $0.91
1996 $3.19 $1.05
1997 $3.67 $1.21
1998 $4.22 $1.39 $46.19
Cost of Equity = 6.25% + 1.40 * 5.5% = 13.95%
PV of Dividends and Terminal Price (@ 13.95%) $27.59
=

36) Church & Dwight, a large producer of sodium bicarbonate, reported earnings per share of $1.50
in 1993 and paid dividends per share of $0.42. In 1993, the firm also reported the following:

Net Income = $30 million

Interest Expense = $0.8 million

Book Value of Debt = $7.6 million

Book Value of Equity = $160 million

The firm faced a corporate tax rate of 38.5%. (The market value debt-to -equity ratio is 5%.) The
treasury bond rate is 7%.

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The firm expects to maintain these financial fundamentals from 1994 to 1998, after which its is
expected to become a stable firm, with an earnings growth rate of 6%. The firm's financial
characteristics will approach industry averages after 1998. The industry averages are as follows:

Return on Assets = 12.5%

Debt/Equity Ratio = 25%

Interest Rate on Debt = 7%

Church and Dwight had a beta of 0.85 in 1993, and the unlevered beta is not expected to change
over time.

A. What is the expected growth rate in earnings, based upon fundamentals, for the high-growth
period (1994 to 1998)?

B. What is the expected payout ratio after 1998?

C. What is the expected beta after 1998?

D. What is the expected price at the end of 1998?

E. What is the value of the stock, using the two-stage dividend discount model?

F. How much of this value can be attributed to extraordinary growth? to stable growth?

Solution

A. Retention Ratio = 1 - Payout Ratio = 1 - 0.42/1.50 = 72%

Return on Assets

= (Net Income + Int Exp (1-t))/(BV of Debt + BV of Equity)

= (30 + 0.8 * (1 - 0.385))/(7.6 + 160) = 18.19%

Debt/Equity Ratio = 7.6/160 = .0475

Interest Rate on Debt = 0.8/7.6 = 10.53%

Expected Growth Rate

= 0.72 [.1819 + .0475 (.1819 - .1053 * (1 - 0.385))] = 13.5%

Alternatively, and much more simply,

Return on Equity = 30/160 = .1875

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Expected Growth Rate = 0.72 * .1875 = 13.5%

B. Expected payout ratio after 1998:

= 1 - g/[ROC + D/E (ROC - i (1-t))]

= 1 - .06/(.125+.25(.125 - .07(1-.385))

= 0.5876

C. Beta in 1993 = 0.85

Unlevered Beta = 0.85/(1 + (1 - 0.385) * 0.05) = 0.8246
Beta After 1998 = 0.8246 * (1 + (1 - 0.385) * 0.25) = 0.95
D. Cost of Equity in 1999 = 7% + 0.95 * 5.5% = 12.23%
Expected Dividend in 1999
= ( $1.50 * 1.1355 * 1.06) * 0.5876 = $1.76
Expected Price at End of 1998 = $1.76/(.1223 - .06) = $28.25
E.
Year EPS DPS
1994 $1.70 $0.48
1995 $1.93 $0.54
1996 $2.19 $0.61
1997 $2.49 $0.70
1998 $2.83 $0.79 $28.25
Cost of Equity = 7% + 0.85 * 5.5% = 11.68%
PV of Dividends and Terminal Price (@ 11.68%) $18.47
=
F. Total Value per Share = $18.47
Value Per Share Using Gordon Growth Model
= $1.50 * 1.06 * 0.5876/(.1223 - .06) = $15.00
Value Per Share With No Growth = $1.50 * 0.5876/.1223 = $7.21
Value of Extraordinary Growth = $18.47 - $15.00 = $3.47
Value of Stable Growth = $15.00 - $7.21 = $7.79

37) Respond true or false to the following statements relating to the calculation and use of FCFE.

A. The free cash flow to equity will generally be more volatile than dividends.
B. The free cash flow to equity will always be higher than the dividends.
C. The free cash flow to equity will always be higher than net income.
D. The free cash flow to equity can never be negative.
Solutions
A. True. Dividends are generally smoothed out. Free cash flows to equity reflect the variability of
the underlying earnings as well as the variability in capital expenditures.
B. False. Firms can have negative free cash flows to equity. Dividends cannot be less than
zero.
C. False. Firms with high capital expenditures, relative to depreciation, may have lower
FCFE than net income.

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D. False. The free cash flow to equity can be negative for companies, which either have
negative net income and/or high capital expenditures, relative to depreciation. This implies
that new stock has to be issued.

38) Kimberly-Clark, a household product manufacturer, reported earnings per share of $3.20 in
1993, and paid dividends per share of $1.70 in that year. The firm reported depreciation of $315
million in 1993, and capital expenditures of $475 million. (There were 160 million shares
outstanding, trading at $51 per share.) This ratio of capital expenditures to depreciation is expected
to be maintained in the long term. The working capital needs are negligible. Kimberly-Clark had
debt outstanding of $1.6 billion, and intends to maintain its current financing mix (of debt and
equity) to finance future investment needs. The firm is in steady state and earnings are expected to
grow 7% a year. The stock had a beta of 1.05. (The treasury bond rate is 6.25%.)

A. Estimate the value per share, using the Dividend Discount Model.
B. Estimate the value per share, using the FCFE Model.
C. How would you explain the difference between the two models, and which one would you use as
your benchmark for comparison to the market price?
solutions
A. Value Per Share = $1.70 * 1.07/(.1203 - .07) = $36.20
(Cost of Equity = 6.25% + 1.05 * 5.50% = 12.03%)
B.
Current Earnings per share $3.20
=
- (1 - Desired Debt Fraction)
*
(Capital Spending - Depreciation) = 83.61%* = $0.84
$1.00
- (1 - Desired Debt Fraction)
*
Working Capital = 83.61% * $0.00 = $0.00
Free Cash Flow to Equity = $2.36
Cost of Equity = 6.25% + 1.05 * 5.5% = 12.03%
Value Per Share = $2.36 * 1.07/(.1203 - .07) = $50.20
This is based upon the assumption that the current ratio of capital expenditures to
depreciation is maintained in perpetuity.
C. The FCFE is greater than the dividends paid. The higher value from the model reflects the
additional value from the cash accumulated in the firm. The FCFE value is more likely to
reflect the true value.

39) Ecolab Inc. sells chemicals and systems for cleaning, sanitizing, and maintenance. It reported
earnings per share of $2.35 in 1993, and expected earnings growth of 15.5% a year from 1994 to
1998, and 6% a year after that. The capital expenditure per share was $2.25, and depreciation was
$1.125 per share in 1993. Both are expected to grow at the same rate as earnings from 1994 to
1998. Working capital is expected to remain at 5% of revenues, and revenues which were $1,000
million in 1993 are expected to increase 6% a year from 1994 to 1998, and 4% a year after that. The
firm currently has a debt ratio (D/(D+E)) of 5%, but plans to finance future investment needs
(including working capital investments) using a debt ratio of 20%. The stock is expected to have a

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beta of 1.00 for the period of the analysis, and the treasury bond rate is 6.50%. (There are 63
million shares outstanding.)

A. Assuming that capital expenditures and depreciation offset each other after 1998, estimate the
value per share.

B. Assuming that capital expenditures continue to be 200% of depreciation even after 1998,
estimate the value per share.

C. What would the value per share have been, if the firm had continued to finance new investments
with its old financing mix (5%)? Is it fair to use the same beta for this analysis?

solutions

A.

Year EPS Cap Depr WC FCFE Term

Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
3 $3.62 $3.47 $1.73 $0.05 $2.19
4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $84.74
6 $5.12 $4.90 $4.90 $0.04 $5.08

The net capital expenditures (Cap Ex - Depreciation) and working capital change is offset
partially by debt (20%). The balance comes from equity. For instance, in year 1:

FCFE = $2.71 - ($2.60 - $1.30) * (1 - 0.20) - $0.05 * (1 - 0.20) = $1.64)

Cost of Equity = 6.5% + 1 * 5.5% = 12%

Terminal Value Per Share = $5.08/(.12 - .06) = $84.74

Present Value Per Share = 1.64/1.12 + 1.89/1.12^2 + 2.19/1.12^3 + 2.54/1.12^4 + (2.93 +

84.74)/1.12^5 = $55.89

B.

Year EPS Cap Depr WC FCFE Term

Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
3 $3.62 $3.47 $1.73 $0.05 $2.19
4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $52.09
6 $5.12 $4.90 $2.45 $0.04 $3.13

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Terminal Value Per Share = $3.13/(.12 - .06) = $52.09

Present Value Per Share = 1.64/1.12 + 1.89/1.12^2 + 2.19/1.12^3 + 2.54/1.12^4 +

(2.93+52.09)/1.12^5 = $37.36

C.

Year EPS Cap Depr WC FCFE Term

Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.43
2 $3.13 $3.00 $1.50 $0.05 $1.66
3 $3.62 $3.47 $1.73 $0.05 $1.92
4 $4.18 $4.00 $2.00 $0.06 $2.23
5 $4.83 $4.62 $2.31 $0.06 $2.58 $45.85
6 $5.12 $4.90 $2.45 $0.04 $2.75

Terminal Value Per Share = $2.75/(.12 - .06) = $45.85

Present Value Per Share = 1.43/1.12 + 1.66/1.12^2 + 1.92/1.12^3 + 2.23/1.12^4 + (2.58 +

45.85)/1.12^5 = $32.87

The beta will probably be lower because of lower leverage.

40) Dionex Corporation, a leader in the development and manufacture of ion chromography
systems (used to identify contaminants in electronic devices), reported earnings per share of $2.02
in 1993, and paid no dividends. These earnings are expected to grow 14% a year for five years
(1994 to 1998) and 7% a year after that. The firm reported depreciation of $2 million in 1993 and
capital spending of $4.20 million, and had 7 million shares outstanding. The working capital is
expected to remain at 50% of revenues, which were $106 million in 1993, and are expected to grow
6% a year from 1994 to 1998 and 4% a year after that. The firm is expected to finance 10% of its
capital expenditures and working capital needs with debt. Dionex had a beta of 1.20 in 1993, and
this beta is expected to drop to 1.10 after 1998. (The treasury bond rate is 7%.)

A. Estimate the expected free cash flow to equity from 1994 to 1998, assuming that capital
expenditures and depreciation grow at the same rate as earnings.

B. Estimate the terminal price per share (at the end of 1998). Stable firms in this industry have
capital expenditures which are 150% of depreciation, and maintain working capital at 25% of
revenues.

C. Estimate the value per share today, based upon the FCFE model.

Solution

A.

Year EPS Cap Deprec WC FCFE Term.

Ex Price
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1 $2.30 $0.68 $0.33 $0.45 $1.57

2 $2.63 $0.78 $0.37 $0.48 $1.82
3 $2.99 $0.89 $0.42 $0.51 $2.11
4 $3.41 $1.01 $0.48 $0.54 $2.45
5 $3.89 $1.16 $0.55 $0.57 $2.83 $52.69
6 $4.16 $0.88 $0.59 $0.20 $3.71

The net capital expenditures (Cap Ex - Depreciation) and working capital change is offset
partially by debt (10%). The balance comes from equity. For instance, in year 1 -

FCFE = $2.30 - ($0.68 - $0.33) * (1 - 0.10) - $0.45 * (1 - 0.10) = $1.57)

B. Terminal Price = $3.71/ (.1305 - .07) = $52.69

C. Present Value Per Share = 1.57/1.136 + 1.82/1.136^2 + 2.11/1.136^3 + 2.45/1.136^4 + (2.83

+ 52.69)/1.136^5 = $35.05

41) Which of the following firms is likely to have a higher value from the dividend discount model,
a higher value from the FCFE model or the same value from both models?

A. A firm that pays out less in dividends than it has available in FCFE, but which invests the
balance in treasury bonds.

B. A firm which pays out more in dividends than it has available in FCFE, and then issues stock to
cover the difference.

C. A firm which pays out, on average, its FCFE as dividends.

D. A firm which pays out less in dividends that it has available in FCFE, but which uses the cash at
regular intervals to acquire other firms, with the intent of diversifying.

E. A firm which pays out more in dividends than it has available in FCFE, but borrows money to
cover the difference. (The firm is already over-levered.)

Solutions

A. Both models should have the same value, as long as a higher growth rate in earnings is used in
the dividend discount model to reflect the growth created by the interest earned, and a lower
beta to reflect the reduction in risk. The reality, however, is that most analysts will not make
this adjustment, and the dividend discount model value will be lower than the FCFE model
value.

B. The dividend discount model will overstate the true value, because it will not reflect the
dilution that is inherent in the issue of new stock.

C. Both models should provide the same value.

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D. Since acquisition, with the intent of diversifying, implies that the firm is paying too much
(i.e., negative net present value), the dividend discount model will provide a lower value than
the FCFE model.

E. If the firm is over-levered to begin with, and borrows more money, there will be a loss of
value from the over-leverage. The FCFE model will reflect this lost value, and will thus
provide a lower estimate of value than the dividend discount model.

42) Respond true or false to the following statements about the free cash flow to the firm.

A. The free cash flow to the firm is always higher than the free cash flow to equity.

B. The free cash flow to the firm is the cumulated cash flow to all investors in the firm, though the
form of their claims may be different.

C. The free cash flow to the firm is a pre-debt, pre-tax cash flow.

D. The free cash flow to the firm is an after-debt, after-tax cash flow.

E. The free cash flow to the firm cannot be estimated without knowing interest and principal
payments, for a firm with debt.

solutions

A. False. It can be equal to the FCFE if the firm has no debt.

B. True.

C. False. It is pre-debt, but after-tax.

D. False. It is after-tax, but pre-debt.

E. False. The free cash flow to firm can be estimated directly from the earnings before interest
and taxes.

43) Lay out how you would get to the free cash flow to the firm (what would you add and/or
subtract to the base number?) from the following measures of cash flow.

A. Net Income

B. Earnings before taxes

C. EBIT (Earnings before interest and taxes)

D. EBITDA (Earnings before interest, taxes, and depreciation)

E. Net Operating Income

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F. Free Cash Flow to Equity

Solutions

A. FCFF = Net Income + Interest (1-t) + Depreciation - Capital Spending – Working Capital

B. FCFF = (Earnings before taxes + Interest Expenses) (1 - tax rate) + Depreciation - Capital
Spending - Working Capital

C. FCFF = EBIT (1- tax rate) + Depreciation - Capital Spending - Working Capital

D. FCFF = (EBITDA - Depreciation) (1- tax rate) + Depreciation - Capital Spending -

Working Capital

E. FCFF = (NOI - Non-operating Expenses) (1- tax rate) + Depreciation - Capital Spending -
Working Capital

F. FCFF = FCFE + Interest Expenses (1 - tax rate) - New Debt Issues + Principal Repayments

* Assumed no preferred stock is outstanding

44) Union Pacific Railroad reported net income of $770 million in 1993, after interest expenses of
$320 million. (The corporate tax rate was 36%.) It reported depreciation of $960 million in that
year, and capital spending was $1.2 billion. The firm also had $4 billion in debt outstanding on the
books, rated AA (carrying a yield to maturity of 8%), trading at par (up from $3.8 billion at the end
of 1992). The beta of the stock is 1.05, and there were 200 million shares outstanding (trading at
$60 per share), with a book value of $5 billion. Union Pacific paid 40% of its earnings as dividends
and working capital requirements are negligible. (The treasury bond rate is 7%.)

A. Estimate the free cash flow to the firm in 1993.

B. Estimate the value of the firm at the end of 1993.
C. Estimate the value of equity at the end of 1993, and the value per share, using the FCFF
approach.
solutions

A. FCFF in 1993 = Net Income + Depreciation - Capital Expenditures - Working Capital +

Interest Expenses (1 - tax rate)

= $770 + $960 - $1200 - 0 + $320 (1 - 0.36) = $734.80 million

B. EBIT = Net Income/(1 - tax rate) + Interest Expenses = 770/0.64 + 320 = $1523.125 million

Return on Assets = EBIT (1-t)/ (BV of Debt + BV of Equity) = 974.80/9000 = 10.83%

Expected Growth Rate in FCFF = Retention Ratio * ROC = 0.6 * 10.83% = 6.50%

Cost of Equity = 7% + 1.05 * 5.5% = 12.775%

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Cost of Capital = 8% (1 - 0.36) (4000/(4000 + 12000)) + 12.775% = (12000/(4000 + 12000)) =

10.86%

Value of the Firm = 734.80/(.1086 - .065) = $16,853 millions

C. Value of Equity = Value of Firm - Market Value of Debt

= $16,853 - $4,000 = $12,853 millions

Value Per Share = $12,853/200 = $64.27

45) Lockheed Corporation, one of the largest defense contractors in the U.S., reported EBITDA of
$1290 million in 1993, prior to interest expenses of $215 million and depreciation charges of $400
million. Capital Expenditures in 1993 amounted to $450 million, and working capital was 7% of
revenues (which were $13,500 million). The firm had debt outstanding of $3.068 billion (in book
value terms), trading at a market value of $3.2 billion, and yielding a pre-tax interest rate of 8%.
There were 62 million shares outstanding, trading at $64 per share, and the most recent beta is 1.10.
The tax rate for the firm is 40%. (The treasury bond rate is 7%.)

The firm expects revenues, earnings, capital expenditures and depreciation to grow at 9.5% a year
from 1994 to 1998, after which the growth rate is expected to drop to 4%. (Capital spending will
offset depreciation in the steady state period.) The company also plans to lower its debt/equity ratio
to 50% for the steady state (which will result in the pre-tax interest rate dropping to 7.5%.)

A. Estimate the value of the firm.

B. Estimate the value of the equity in the firm and the value per share.

Solutions

A.

Y EBITDA Deprec'n EBIT EBIT Cap _ FCFF Term

r WC
(1-t) Exp. Value
0 $1,290 $400 $890 $534 $450 $82 $402
1 $1,413 $438 $975 $585 $493 $90 $440
2 $1,547 $480 $1,067 $640 $540 $98 $482
3 $1,694 $525 $1,169 $701 $591 $108 $528
4 $1,855 $575 $1,280 $768 $647 $118 $578
5 $2,031 $630 $1,401 $841 $708 $129 $633 $14,326

'93-97 After 1998

Cost of Equity = 13.05% 12.30%
AT Cost of Debt = 4.80% 4.50%
Cost of Capital = 9.37% 9.69%

Terminal Value

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= {EBIT (1-t)(1+g) - (Rev1998 - Rev1997) * WC as % of Rev}/(WACC-g)

= (841 * 1.04) - (13500 * 1.0955 * 1.04 - 13500 * 1.0955)

* 0.07 /(.0969-.04) = $14,326

Value of the Firm

= 440/1.0937 + 482/1.09372 + 528/1.09373 + 578/1.09374 + (633 + 14941)/1.09375 = $11,172

B. Value of Equity in the Firm = ($11566 - Market Value of Debt) = 11172 - 3200 = $7,972

Value Per Share = $7,972/62 = $128.57

46) In the face of disappointing earnings results and increasingly assertive institutional
stockholders, Eastman Kodak was considering a major restructuring in 1993. As part of this
restructuring, it was considering the sale of its health division, which earned $560 million in
earnings before interest and taxes in 1993, on revenues of $5.285 billion. The expected growth in
earnings was expected to moderate to 6% between 1994 and 1998, and to 4% after that. Capital
expenditures in the health division amounted to $420 million in 1993, while depreciation was $350
million. Both are expected to grow 4% a year in the long term. Working capital requirements are
negligible.

The average beta of firms competing with Eastman Kodak's health division is 1.15. While Eastman
Kodak has a debt ratio (D/(D+E)) of 50%, the health division can sustain a debt ratio (D/(D+E)) of
only 20%, which is similar to the average debt ratio of firms competing in the health sector. At this
level of debt, the health division can expect to pay 7.5% on its debt, before taxes. (The tax rate is
40%, and the treasury bond rate is 7%.)

A. Estimate the cost of capital for the division.

B. Estimate the value of the division.
C. Why might an acquirer pay more than this estimated value?

Solutions
A. Beta for the Health Division = 1.15

Cost of Equity = 7% + 1.15 * 5.5% = 13.33%

Cost of Capital = 13.33% * 0.80 + (7.5% * 0.6) * 0.2 = 11.56%

B.

Year Deprec'n EBIT EBIT(1- Cap FCFF Term

t) Ex Val
0 $350 $560 $336 $420 $266
1 $364 $594 $356 $437 $283
2 $379 $629 $378 $454 $302
3 $394 $667 $400 $472 $321
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4 $409 $707 $424 $491 $342

5 $426 $749 $450 $511 $364 $5,014

Now After 5 years

Cost of Equity = 13.33% 13.33%
Cost of Debt = 4.50% 4.50%
Cost of Capital = 11.56% 11.56%

Value of the Division = 283/1.1156 + 302/1.11562 + 321/1.11563 + 342/1.11564 + (364 +

5014)/1.11565 = $4,062 millions

C. There might be potential for synergy, with an acquirer with related businesses. The health
division at Kodak might also be mismanaged, creating the potential for additional value from
better management.

47) Intermet Corporation, the largest independent iron foundry organization in the country, reported
a deficit per share of $0.15 in 1993. The earnings per share from 1984 to 1992, were as follows:

Year EPS
1984 $0.69
1985 $0.71
1986 $0.90
1987 $1.00
1988 $0.76
1989 $0.68
1990 $0.09
1991 $0.16
1992 <$0.07>

The firm had capital expenditures of $1.60 per share, and depreciation per share of $1.20 in 1993.
Working capital was expected to increase $0.10 per share in 1994. The stock has a beta of 1.2,
which is expected to remain unchanged, and finances its capital expenditure and working capital
requirements with 40% debt. (D/(D+E)). The firm is expected, in the long term, to grow at the same
rate as the economy (6%).

A. Estimate the normalized earnings per share in 1994, using the average earnings approach.
B. Estimate the normalized free cash flow to equity per share in 1994, using the average earnings
approach.
C. The firm is expected, in the long term, to grow at the same rate as the economy (6%).
Solutions

A.

Year EPS
1984 $0.69
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1985 $0.71
1986 $0.90
1987 $1.00
1988 $0.76
1989 $0.68
1990 $0.09
1991 $0.16
1992 ($0.07)
1993 ($0.15)

Average Earnings Per Share = $0.48

Normalized Earnings Per Share in 1994 = $0.48 * 1.06 = $0.51

B.

Normalized Earnings Per Share = $0.51

- (Cap Ex - Deprec'n) * (1 - Debt ratio) = $0.25
- Working Capital * (1- Debt ratio) = $0.06
Normalized FCFE Next Year = $0.19
(Assume that capital expenditures and depreciation will grow
6% in 1994.)

48) Chrysler Corporation reported a significant loss of $2.74 per share in 1991, but reported
positive earnings per share of $1.38 in 1992, as sales improved and profit margins increased. The
improving economy is expected to quadruple earnings in 1993, after which earnings growth is
expected to stabilize at 5% in the long term. Chrysler also reported capital spending per share of
$5.50 and depreciation per share of $4.50 in 1992, and both items are expected to grow 5% a year
in the long term. The working capital for the firm amounted to $2.50 per share in 1992, and was
expected to grow 3% a year in the long term. The beta for the stock is 1.25, but is expected to
stabilize at 1.10 after 1993. The firm expects to maintain a debt ratio of 40%. The treasury bond rate
is 7%.

A. Estimate the value per share.

B. How sensitive is this estimate to assumptions about growth in 1993?
Solutions
A.
Earnings Per Share Next Year = $5.52
- (Cap Ex - Deprec'n) *(1- Debt ratio) = $0.63
- ( _ Working Capital) * (1 - Debt ratio) = $0.045
FCFE Next Year = $4.845
Cost of Equity = 7% + 1.1 * 5.5% = 13.05%
Expected Growth Rate = 5.00%
Capital Expenditures - Depreciation = ($5.50 * 1.05 - $4.50 * 1.05)
Debt Ratio = 40%
Value Per Share = $4.85/(.1305 - .05) = $60.19

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B. The value is very sensitive to assumptions about growth in 1993. If the earnings do not
quadruple in 1993, the free cash flow to equity will be significantly below $4.85, and the value
lower than $60.19.
49) Kollmorgen Corporation, a diversified technology company, reported sales of $194.9 million in
1992, and had a net loss of $1.9 million in that year. Its net income had traced a fairly volatile
course over the previous five years:
Year Net Income
1987 $0.3 million
1988 $11.5 million
1989 -$2.4 million
1990 $7.2 million
1991 -$4.6 million

The stock had a beta of 1.20, and the normalized net income is expected to increase 6% a year until
1996, after which the growth rate is expected to stabilize at 5% a year (the beta will drop to 1.00).
The depreciation amounted to $8 million in 1992, and capital spending amounted to $10 million in
that year. Both items are expected to grow 5% a year in the long term. The firm expects to maintain
a debt ratio of 35%. (The treasury bond rate is 7%.)

A. Assuming that the average earnings from 1987 to 1992 represents the normalized earnings,
estimate the normalized earnings and free cash flow to equity.

B. Estimate the value per share.

Solutions

A.
Year Net
Income
(in
millions)
1987 $0.30
1988 $11.50
1989 ($2.40)
1990 $7.20
1991 ($4.60)
1992 ($1.90)
Average = $1.68
Net Income = $1.68
- (Cap Ex - Deprec'n) * (1 - Debt ratio) 1.30
=
= FCFE = $0.38
B. Cost of Equity (until 1996) = 7% +1.2 * 5.5% = 13.6%
Cost of Equity (after 1996) = 7% + 5.5% = 12.5%
Year Net (Cap. Ex - FCFE Terminal
Income Deprec'n) * Value
(1 - Debt
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Ratio)
1993 $1.78 $1.37 $0.42
1994 $1.89 $1.43 $0.45
1995 $2.00 $1.50 $0.50
1996 $2.12 $1.58 $0.54 $29.73
Term $2.23 $0.00 $2.23
Year
Capital expenditures are offset by depreciation in the terminal year.
Terminal Value = $2.23/(.125 - .05) = $29.73
Value of Equity
= 0.42/1.136 + 0.45/1.136^2 + 0.50/1.136^3 + (0.54 + 29.73)/1.136^4
= $19.24 million

50) Delta Airlines, the third ranking domestic airline, had revenues of $12 billion in 1993 and
reported a loss of $415 million in that year. Between 1988 and 1990, which was the last period of
significant profitability for the firm, the firm had a pre-tax operating margin of 12% (Pre-tax
Operating Margin = EBIT/Sales). Delta Airlines had interest expenses of $340 million in 1993, and
its capital expenditures were offset by depreciation. The company faces a tax rate of 40%. The
stock had a beta of 1.15, and the treasury bond rate is 7%. Working capital requirements are
negligible.
The expected growth rate in revenues/net incomes is 6% in the long term.
A. Assuming that the firm returns to 1988-90 levels of profitability by 1994, estimate the value of
equity.
B. Estimate the value of equity, if the firm does not return to 1988-90 levels of profitability until
1995. (The firm continues to lose money in 1994.)

Solutions

A.

EBIT (based upon operating margin of 12%) $1,440

=
Interest Expenses = $340
Earnings Before Taxes = $1,100
Taxes (at 40%) = $440
Net Income (also FCFE)= $660
Cost of Equity = 7% + 1.15 * 5.5% = 13.33%
Expected Growth Rate in FCFE = 6.00%
Value of Equity= (660 * 1.06)/ (.1333 - .06) = $9,010

B. Value of Equity (assuming two year delay in return to profitability)

= 9010/1.133252 = $7,016 million

51) OHM Corporation, an environmental service provider, had revenues of $209 million in 1992
and reported losses of $3.1 million. It had earnings before interest and taxes of $12.5 million in
1992, and had debt outstanding of $109 million (in market value terms). There are 15.9 million

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shares outstanding, trading at $11 per share. The pre-tax interest rate on debt owed by the firm is
8.5%, and the stock has a beta of 1.15. The firm's EBIT is expected to increase 10% a year from
1993 to 1996, after which the growth rate is expected to drop to 4% in the long term. Capital
expenditures will be offset by depreciation, and working capital needs are negligible. (The
corporate tax rate is 40%, and the treasury bond rate is 7%.)

A. Estimate the cost of capital for OHM.

B. Estimate the value of the firm.

C. Estimate the value of equity (both total and on a per share basis).

Solutions

A.

Equity Debt
Market Value 61.61% 38.39%
Weight
Cost of Component 13.33% 5.10%

Cost of Capital = 13.33% (0.6161) + 5.1% (0.3839) = 10.17%

B.

Year 1993 1994 1995 1996 Terminal

Year
EBIT (1-t) $8.25 $9.08 $9.98 $10.98 $11.42
- (Cap Ex - Deprec'n) $0.00 $0.00 $0.00 $0.00 $0.00
- Working Capital $0.00 $0.00 $0.00 $0.00 $0.00
= FCFF $8.25 $9.08 $9.98 $10.98 $11.42
Terminal Value $185.18

Terminal Value = $11.42/(.1017 - .04) = $185.18

Present Value = $8.25/1.1017 + $9.08/1.1017^2 + $9.98/1.1017^3 + ($10.98 + $185.18)/1.1017^4

= $155.60 million

C. Value of Equity = Value of Firm - Market Value of Debt = $155.60 - $109 = $46.60 million

Value of Equity Per Share = $46.60/15.9 = $2.93

52) You have been asked by the owner of a small firm that produces and sells computer software to
estimate the value of his firm. The firm had revenues of $20 million in the most recent year, on
which it made earnings before interest and taxes of $2 million. The firm had debt outstanding of
$10 million, on which pre-tax interest expenses amounted to $1 million. The book value of equity is
$10 million. The average beta of publicly traded firms that are in the same business is 1.30, and the
average debt-equity ratio is 0.2 (based upon the market value of equity). The market value of equity
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of these firms is, on average, three times the book value of equity. All firms face a 40% tax rate.
Capital expenditures amounted to $1 million in the most recent year, and were twice the
depreciation charge in that year. Both items are expected to grow at the same rate as revenues for
the next five years, and to offset each other in steady state.

The revenues of this firm are expected to grow 20% a year for the next five years, and 5% after that.
Net income is expected to increase 25% a year for the next five years, and 8% after that. The
treasury bond rate is 7%.

A. Estimate the cost of equity for this private firm.

B. Estimate the cost of capital for this private firm.

C. Estimate the value of the owner's stake in this private firm, using both the firm approach and the
equity approach.

Solutions

A. Unlevered Beta for Publicly Traded Firms in Same Business

= 1.30/(1 + 0.6 * 0.2) = 1.16

Debt/Equity Ratio for Private Firm

= Debt/Estimated Market Value of Equity = 10/30 = 33.33%

New Levered Beta For Private Firm = 1.16 * (1 + 0.6 * .3333) = 1.39

New Cost Of Equity = 7% + 1.39 * 5.5% = 14.66%

B. Pre-Tax Cost of Debt = $1/$10 = 10%

After-Tax Cost of Debt = 10% (1 - 0.4) = 6%

Cost of Capital = 6% (0.25) + 14.66% (0.75) = 12.49%

C. Using the Firm Approach:

1 2 3 4 5 Terminal
year
EBIT $2.40 $2.88 $3.46 $4.15 $4.98 $5.23
EBIT (1 - tax rate) $1.44 $1.73 $2.07 $2.49 $2.99 $3.14
- (Cap Ex - Deprec'n) $0.60 $0.72 $0.86 $1.04 $1.24 $0.00
= FCFF $0.84 $1.01 $1.21 $1.45 $1.74 $3.14
Terminal Value $41.8
5

Terminal Value = $3.14/(.1249 - .05) = $41.85

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Present Value (Value of Firm) (@ 12.49%) = $0.84/1.1249 + $1.01/1.12492 + $1.21/1.12493 +

$1.45/1.12494 + ($1.74 + $41.85)/1.12495 = $27.50 million

Value of Equity = $27.50 million - $10 million = $17.50 million

Using the Equity approach:

1 2 3 4 5 Terminal
year
Net Income $0.75 $0.9 $1.17 $1.4 $1.83 $1.98
4 6
- (Cap Ex - Deprec'n) * (1- Debt ratio) =
$0.45 $0.5 $0.65 $0.7 $0.93 $0.00
4 8
= FCFE $0.30 $0.4 $0.52 $0.6 $0.90 $1.98
0 9
Terminal Value of Equity $29.71

Terminal Value of Equity = $1.98/(.1466 - .05) = $29.71

Present Value (using Cost of Equity of 14.66%) = $0.30/1.1466 + $0.40/1.14662 + $0.52/1.14663

+ $0.69/1.14664 + ($0.90 + $29.71)/1.14665 = $16.76 million

53) Boston Chicken, a company selling roasted chickens and accompaniments in outlets through the
country, went public in 1993. In the year prior to going public, it had revenues of $40 million, on
which it reported earnings before interest and taxes of $12 million. The firm had no debt
outstanding, and expected revenues to grow 35% a year from 1993 to 1997, 15% a year from 1998
to 2000, and 5% a year after that, while pre-tax operating margins (EBIT/Revenues) were expected
to remain stable. Capital expenditures ñ which exceeded depreciation by $5 million in the year prior
to going public ñ were expected to grow 20% a year from 1993 to 1997, as is depreciation. After
1998, capital expenditures are expected to offset depreciation. Working capital requirements are
negligible.

The average beta of publicly traded fast-food chains with which Boston Chicken will be competing
is 1.15, and their average debt-equity ratio is 25%. Boston Chicken plans to maintain its policy of
no debt until 1997, and to move to the industry average debt ratio after that (the pre-tax cost of debt
is expected to be 8%). The treasury bond rate is 7%. All firms face a tax rate of 40%. What is the
value of the firm

solutions

A. Unlevered Beta for Comparable Firms = 1.15/(1 + 0.6 * .25) = 1.00

Cost of Equity (until 1997) = 7% + 5.5% = 12.50%

Cost of Capital (until 1997) = 12.50%

Beta after 1997 for Boston Chicken = 1.15

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Cost of Equity (after 1997) = 7% + 1.15 * 5.5% = 13.325%

Cost of Capital (after 1997)

= 13.325% (0.8) + 8% (1 - 0.4) (0.2) = 11.62%

B.

1993 1994 1995 1996 1997 1998 1999 2000 Terminal

year
EBIT (1-t) $9.72 $13.12 $17.71 $23.9 $32.29 $37.13 $42.70 $49.1 $51.56
1 0
Cap Ex - $6.00 $7.20 $8.64 $10.3 $12.44 $0.00 $0.00 $0.00 $0.00
Deprec'n 7
FCFF $3.72 $5.92 $9.07 $13.5 $19.84 $37.13 $42.70 $49.1 $51.56
5 0
$778.80

Terminal Value = $51.56 /(.1162 - .05) = $778.80 million

Present Value (using 12.50% for the first five years, and 11.62% after that) =$3.72/1.125 +
$5.92/1.1252 + $9.07/1.1253 + $13.55/1.1254 + $19.84/1.1255 + $37.13/(1.1255 * 1.1162) +
$42.70/(1.1255 * 1.11622) + ($49.10 + 778.80)/(1.1255 * 1.11623) = $401.67 million

This is both the value of the firm and the value of equity.

1. The $1,000 face value ABC bond has a coupon rate of 6%, with interest paid semi-annually,
and matures in 5 years. If the bond is priced to yield 8%, what is the bond's value today?
o FV = $1,000
o CF = $60/2 = $30
o N = 5 x 2 = 10
o i = 8%/2 = 4%
o PV = $918.89
2. The $1,000 face value EFG bond has a coupon of 10% (paid semi-annually), matures in 4
years, and has current price of $1,140. What is the EFG bond's yield to maturity?
o FV = $1,000
o CF = $100/2 = $50
o N=4x2=8
o PV = $1,140
o i = 3%
o yield-to-maturity = 3% x 2 = 6%
3. The HIJ bond has a current price of $800, a maturity value of $1,000, and matures in 5
years. If interest is paid semi-annually and the bond is priced to yield 8%, what is the bond's
annual coupon rate?
o PV = $800
o FV = $1,000

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o N = 5 x 2 = 10
o i = 8% / 2 = 4%
o CF = $15.34
o Coupon = $30.68 per year or 3.068%
4. The KLM bond has a 8% coupon rate (with interest paid semi-annually), a maturity value of
$1,000, and matures in 5 years. If the bond is priced to yield 6%, what is the bond's current
price?
o CF = $40
o FV = $1,000
o N = 10
o i = 6%/2 = 3%
o PV = $1,085
5. The NOP bond has an 8% coupon rate (semi-annual interest), a maturity value of $1,000,
matures in 5 years, and a current price of $1,200. What is the NOP's yield-to-maturity?
o CF = $40
o FV = $1,000
o N = 5 x 2 = 10
o PV = $1,200
o i = 1.797%
o yield-to-maturity = 1.797% x 2 = 3.594%

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